International Financial Management , Ninth Edition

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International Financial Management ninth edition

Jeff Madura Florida Atlantic University

International Financial Management, Ninth Edition Jeff Madura VP/Editorial Director: Jack W. Calhoun

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COPYRIGHT © 2008, 2006 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Printed in the United States of America 1 2 3 4 5 10 09 08 Student Edition: ISBN 13: 978-0-324-56820-2 ISBN 10: 0-324-56820-7 Student Edition PKG: ISBN 13: 978-0-324-56819-6 ISBN 10: 0-324-56819-3 Instructor’s Edition: ISBN 13: 978-0-324-65474-5 ISBN 10: 0-324-65474-X Instructor’s Edition PKG: ISBN 13: 9978-0-324-65473-8 ISBN 10: 0-324-65473-1

07

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Dedicated to my parents

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Brief Contents

Part 1: The International Financial Environment 1. 2. 3. 4. 5.

1

Multinational Financial Management: An Overview 2 International Flow of Funds 22 International Financial Markets 50 Exchange Rate Determination 85 Currency Derivatives 103

Part 2: Exchange Rate Behavior

153

6. Government Influence on Exchange Rates 154 7. International Arbitrage and Interest Rate Parity 188 8. Relationships among Inflation, Interest Rates, and Exchange Rates 214

Part 3: Exchange Rate Risk Management

249

9. Forecasting Exchange Rates 250 10. Measuring Exposure to Exchange Rate Fluctuations 280 11. Managing Transaction Exposure 307 12. Managing Economic Exposure and Translation Exposure 346

Part 4: Long-Term Asset and Liability Management 13. 14. 15. 16. 17. 18.

369

Direct Foreign Investment 370 Multinational Capital Budgeting 387 International Acquisitions 422 Country Risk Analysis 446 Multinational Cost of Capital and Capital Structure 472 Long-Term Financing 500

Part 5: Short-Term Asset and Liability Management

529

19. Financing International Trade 530 20. Short-Term Financing 549 21. International Cash Management 569 Appendix A: Answers to Self Test Questions 606 Appendix B: Supplemental Cases 618 Appendix C: Using Excel to Conduct Analysis 640 Appendix D: International Investing Project 647 Appendix E: Discussion in the Boardroom 650 Glossary 658 Index 665

v

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Contents

Blades, Inc. Case: Decision to Expand Internationally, 19 Small Business Dilemma: Developing a Multinational Sporting Goods Corporation, 20 Internet/Excel Exercises, 21

Preface, xvii

Part 1: The International Financial Environment

1

Chapter 1: Multinational Financial Management: An Overview

2

Managing the MNC, 2

Facing Agency Problems, 3 Governance: How SOX Improved Corporate Governance of MNCs, 3

Management Structure of an MNC, 4 Why Firms Pursue International Business, 5

Theory of Comparative Advantage, 6 Imperfect Markets Theory, 6 Product Cycle Theory, 6 How Firms Engage in International Business, 7

International Trade, 8 Licensing, 8 Franchising, 9 Joint Ventures, 9 Acquisitions of Existing Operations, 9 Establishing New Foreign Subsidiaries, 9 Summary of Methods, 10 Valuation Model for an MNC, 11

Domestic Model, 11 Valuing International Cash Flows, 12 Uncertainty Surrounding an MNC’s Cash Flows, 14 Organization of the Text, 15 Summary, 16 Point Counter-Point: Should an MNC Reduce Its Ethical Standards to Compete Internationally?, 16 Self Test, 16 Questions and Applications, 17 Advanced Questions, 17 Discussion in the Boardroom, 19 Running Your Own MNC, 19

Chapter 2: International Flow of Funds

22

Balance of Payments, 22

Current Account, 22 Capital and Financial Accounts, 23 International Trade Flows, 25

Distribution of U.S. Exports and Imports, 26 U.S. Balance-of-Trade Trend, 26 International Trade Issues, 28

Events That Increased International Trade, 28 Trade Friction, 31 Governance: Should Managers Outsource to Satisfy Shareholders?, 32

Factors Affecting International Trade Flows, 34

Impact of Inﬂation, 34 Impact of National Income, 34 Impact of Government Policies, 35 Impact of Exchange Rates, 35 Interaction of Factors, 36 Correcting a Balance-of-Trade Deﬁcit, 36

Why a Weak Home Currency Is Not a Perfect Solution, 37 International Capital Flows, 38

Distribution of DFI by U.S. Firms, 38 Distribution of DFI in the United States, 39 Factors Affecting DFI, 40 Factors Affecting International Portfolio Investment, 41 Impact of International Capital Flows, 41 Agencies That Facilitate International Flows, 42

International Monetary Fund, 42 World Bank, 43 World Trade Organization, 44 International Financial Corporation, 44 vii

viii

Contents

International Development Association, 45 Bank for International Settlements, 45 Organization for Economic Cooperation and Development, 45 Regional Development Agencies, 45 How International Trade Affects an MNC’s Value, 45 Summary, 46 Point Counter-Point: Should Trade Restrictions Be Used to Influence Human Rights Issues?, 46 Self Test, 46 Questions and Applications, 47 Advanced Questions, 47 Discussion in the Boardroom, 47 Running Your Own MNC, 47 Blades, Inc. Case: Exposure to International Flow of Funds, 48 Small Business Dilemma: Identifying Factors That Will Affect the Foreign Demand at the Sports Exports Company, 48 Internet/Excel Exercises, 49

Chapter 3: International Financial Markets

50

Foreign Exchange Market, 50

History of Foreign Exchange, 50 Foreign Exchange Transactions, 51 Foreign Exchange Quotations, 54 Interpreting Foreign Exchange Quotations, 56 Forward, Futures, and Options Markets, 58 International Money Market, 59

Origins and Development, 60 Money Market Interest Rates among Currencies, 61 Standardizing Global Bank Regulations, 61 International Credit Market, 63

Syndicated Loans, 63 International Bond Market, 64

Eurobond Market, 64 Development of Other Bond Markets, 65 International Stock Markets, 66

Issuance of Stock in Foreign Markets, 66 Issuance of Foreign Stock in the United States, 66 Listing of Stock by Non-U.S. Firms on U.S. Stock Exchanges, 67 Governance: Effect of Sarbanes-Oxley Act on Foreign Stock Offerings, 67

Investing in Foreign Stock Markets, 67 How Stock Market Characteristics Vary among Countries, 70 How Financial Markets Facilitate MNC Functions, 70 Summary, 71 Point Counter-Point: Should Firms That Go Public Engage in International Offerings?, 72

Self Test, 72 Questions and Applications, 72 Advanced Questions, 73 Discussion in the Boardroom, 74 Running Your Own MNC, 74 Blades, Inc. Case: Decisions to Use International Financial Markets, 74 Small Business Dilemma: Use of the Foreign Exchange Markets by the Sports Exports Company, 75 Internet/Excel Exercises, 75 Appendix 3: Investing in International Financial Markets, 76

Chapter 4: Exchange Rate Determination

85

Measuring Exchange Rate Movements, 85 Exchange Rate Equilibrium, 86

Demand for a Currency, 87 Supply of a Currency for Sale, 87 Equilibrium, 88 Factors That Inﬂuence Exchange Rates, 89

Relative Inﬂation Rates, 89 Relative Interest Rates, 90 Relative Income Levels, 92 Government Controls, 92 Expectations, 93 Interaction of Factors, 93 Speculating on Anticipated Exchange Rates, 95 Summary, 97 Point Counter-Point: How Can Persistently Weak Currencies Be Stabilized?, 97 Self Test, 98 Questions and Applications, 98 Advanced Questions, 99 Discussion in the Boardroom, 100 Running Your Own MNC, 100 Blades, Inc. Case: Assessment of Future Exchange Rate Movements, 101 Small Business Dilemma: Assessment by the Sports Exports Company of Factors That Affect the British Pound’s Value, 101 Internet/Excel Exercises, 102

Chapter 5: Currency Derivatives Forward Market, 103

How MNCs Use Forward Contracts, 104 Non-Deliverable Forward Contracts, 107 Currency Futures Market, 108

Contract Speciﬁcations, 108 Trading Futures, 108

103

Contents

Comparison of Currency Futures and Forward Contracts, 110 Pricing Currency Futures, 110 Credit Risk of Currency Futures Contracts, 111 Speculation with Currency Futures, 111 How Firms Use Currency Futures, 112 Closing Out a Futures Position, 113 Trading Platforms for Currency Futures, 114 Currency Options Market, 114

Option Exchanges, 114 Over-the-Counter Market, 114 Currency Call Options, 115

Factors Affecting Currency Call Option Premiums, 115 How Firms Use Currency Call Options, 116 Speculating with Currency Call Options, 117 Currency Put Options, 119

Factors Affecting Currency Put Option Premiums, 119 Hedging with Currency Put Options, 120 Speculating with Currency Put Options, 120 Contingency Graphs for Currency Options, 122

Contingency Graph for a Purchaser of a Call Option, 122 Contingency Graph for a Seller of a Call Option, 123 Contingency Graph for a Buyer of a Put Option, 124 Contingency Graph for a Seller of a Put Option, 124 Governance: Should an MNC’s Managers Use Currency Derivatives to Speculate?, 124

Conditional Currency Options, 124 European Currency Options, 126 Summary, 126 Point Counter-Point: Should Speculators Use Currency Futures or Options?, 126 Self Test, 127 Questions and Applications, 127 Advanced Questions, 130 Discussion in the Boardroom, 132 Running Your Own MNC, 132 Blades, Inc. Case: Use of Currency Derivative Instruments, 133 Small Business Dilemma: Use of Currency Futures and Options by the Sports Exports Company, 134 Internet/Excel Exercises, 134 Appendix 5A: Currency Option Pricing, 135

Part 2: Exchange Rate Behavior Chapter 6: Government Influence on Exchange Rates

ix

153 154

Exchange Rate Systems, 154

Fixed Exchange Rate System, 154 Freely Floating Exchange Rate System, 156 Managed Float Exchange Rate System, 158 Pegged Exchange Rate System, 158 Currency Boards Used to Peg Currency Values, 161 Dollarization, 163 Classiﬁcation of Exchange Rate Arrangements, 163 A Single European Currency, 164

Membership, 165 Impact on European Monetary Policy, 165 Impact on Business within Europe, 165 Impact on the Valuation of Businesses in Europe, 166 Impact on Financial Flows, 166 Impact on Exchange Rate Risk, 167 Status Report on the Euro, 167 Government Intervention, 167

Reasons for Government Intervention, 167 Direct Intervention, 168 Indirect Intervention, 171 Intervention as a Policy Tool, 172

Inﬂuence of a Weak Home Currency on the Economy, 172 Inﬂuence of a Strong Home Currency on the Economy, 172 Summary, 174 Point Counter-Point: Should China Be Forced to Alter the Value of Its Currency?, 174 Self Test, 175 Questions and Applications, 175 Advanced Questions, 176 Discussion in the Boardroom, 176 Running Your Own MNC, 176 Blades, Inc. Case: Assessment of Government Influence on Exchange Rates, 177 Small Business Dilemma: Assessment of Central Bank Intervention by the Sports Exports Company, 178 Internet/Excel Exercises, 178 Appendix 6: Government Intervention during the Asian Crisis, 179

Appendix 5B: Currency Option Combinations, 139

Chapter 7: International Arbitrage and Interest Rate Parity

Part 1 Integrative Problem: The International Financial Environment, 152

International Arbitrage, 188

Locational Arbitrage, 188

188

x

Contents

Triangular Arbitrage, 191 Covered Interest Arbitrage, 194 Comparison of Arbitrage Effects, 197

Why the International Fisher Effect Does Not Occur, 231 Comparison of the IRP, PPP, and IFE Theories, 231

Interest Rate Parity (IRP), 198

Derivation of Interest Rate Parity, 198 Determining the Forward Premium, 199 Graphic Analysis of Interest Rate Parity, 200 How to Test Whether Interest Rate Parity Exists, 202 Interpretation of Interest Rate Parity, 202 Does Interest Rate Parity Hold?, 203 Considerations When Assessing Interest Rate Parity, 204 Forward Premiums across Maturity Markets, 205 Changes in Forward Premiums, 206 Governance: How Arbitrage Reduces the Need to Monitor Transaction Costs, 207 Summary, 207 Point Counter-Point: Does Arbitrage Destabilize Foreign Exchange Markets?, 208 Self Test, 208 Questions and Applications, 209 Advanced Questions, 210 Discussion in the Boardroom, 211 Running Your Own MNC, 211 Blades, Inc. Case: Assessment of Potential Arbitrage Opportunities, 211 Small Business Dilemma: Assessment of Prevailing Spot and Forward Rates by the Sports Exports Company, 213 Internet/Excel Exercises, 213

Chapter 8: Relationships among Inflation, Interest Rates, and Exchange Rates

Summary, 232 Point Counter-Point: Does PPP Eliminate Concerns about Long-Term Exchange Rate Risk?, 233 Self Test, 233 Questions and Applications, 234 Advanced Questions, 235 Discussion in the Boardroom, 237 Running Your Own MNC, 237 Blades, Inc. Case: Assessment of Purchasing Power Parity, 238 Small Business Dilemma: Assessment of the IFE by the Sports Exports Company, 239 Internet/Excel Exercises, 239 Part 2 Integrative Problem: Exchange Rate Behavior, 240 Midterm Self Exam, 241

Part 3: Exchange Rate Risk Management Chapter 9: Forecasting Exchange Rates

249 250

Why Firms Forecast Exchange Rates, 250 Forecasting Techniques, 252

Technical Forecasting, 253 Fundamental Forecasting, 254 Market-Based Forecasting, 258 Mixed Forecasting, 261

214

Purchasing Power Parity (PPP), 214

Interpretations of Purchasing Power Parity, 214 Rationale behind Purchasing Power Parity Theory, 215 Derivation of Purchasing Power Parity, 216 Using PPP to Estimate Exchange Rate Effects, 217 Graphic Analysis of Purchasing Power Parity, 218 Testing the Purchasing Power Parity Theory, 219 Why Purchasing Power Parity Does Not Occur, 222 Purchasing Power Parity in the Long Run, 223 International Fisher Effect (IFE), 223

Relationship with Purchasing Power Parity, 223 Implications of the IFE for Foreign Investors, 224 Derivation of the International Fisher Effect, 225 Graphic Analysis of the International Fisher Effect, 227 Tests of the International Fisher Effect, 229

Forecasting Services, 262

Reliance on Forecasting Services, 262 Forecast Error, 263

Potential Impact of Forecast Errors, 263 Measurement of Forecast Error, 263 Forecast Accuracy over Time, 264 Forecast Accuracy among Currencies, 264 Forecast Bias, 265 Graphic Evaluation of Forecast Performance, 266 Comparison of Forecasting Methods, 269 Forecasting under Market Efﬁciency, 269 Governance: Governance of Managerial Forecasting, 270

Using Interval Forecasts, 270

Methods of Forecasting Exchange Rate Volatility, 271 Summary, 272 Point Counter-Point: Which Exchange Rate Forecast Technique Should MNCs Use?, 272

Contents Self Test, 273 Questions and Applications, 273 Advanced Questions, 275 Discussion in the Boardroom, 277 Running Your Own MNC, 277 Blades, Inc. Case: Forecasting Exchange Rates, 277 Small Business Dilemma: Exchange Rate Forecasting by the Sports Exports Company, 278 Internet/Excel Exercises, 278

Chapter 10: Measuring Exposure to Exchange Rate Fluctuations Is Exchange Rate Risk Relevant?, 280

Purchasing Power Parity Argument, 280 The Investor Hedge Argument, 280 Currency Diversiﬁcation Argument, 281 Stakeholder Diversiﬁcation Argument, 281 Response from MNCs, 281 Types of Exposure, 281 Transaction Exposure, 282

Estimating “Net” Cash Flows in Each Currency, 282 Measuring the Potential Impact of the Currency Exposure, 284 Assessing Transaction Exposure Based on Value at Risk, 286 Economic Exposure, 289

Economic Exposure to Local Currency Appreciation, 291 Economic Exposure to Local Currency Depreciation, 291 Economic Exposure of Domestic Firms, 292 Measuring Economic Exposure, 292 Translation Exposure, 295

Does Translation Exposure Matter?, 295 Determinants of Translation Exposure, 296 Examples of Translation Exposure, 297 Summary, 297 Point Counter-Point: Should Investors Care about an MNC’s Translation Exposure?, 298 Self Test, 298 Questions and Applications, 299 Advanced Questions, 300 Discussion in the Boardroom, 304 Running Your Own MNC, 304 Blades, Inc. Case: Assessment of Exchange Rate Exposure, 304 Small Business Dilemma: Assessment of Exchange Rate Exposure by the Sports Exports Company, 305 Internet/Excel Exercises, 306

280

Chapter 11: Managing Transaction Exposure Transaction Exposure, 307

Identifying Net Transaction Exposure, 307 Adjusting the Invoice Policy to Manage Exposure, 308 Governance: Aligning Manager Compensation with Hedging Goals, 308

Hedging Exposure to Payables, 308

Forward or Futures Hedge on Payables, 309 Money Market Hedge on Payables, 309 Call Option Hedge, 310 Summary of Techniques Used to Hedge Payables, 313 Selecting the Optimal Technique for Hedging Payables, 313 Optimal Hedge versus No Hedge, 316 Evaluating the Hedge Decision, 316 Hedging Exposure To Receivables, 317

Forward or Futures Hedge on Receivables, 317 Money Market Hedge on Receivables, 317 Put Option Hedge, 318 Selecting the Optimal Technique for Hedging Receivables, 320 Optimal Hedge versus No Hedge, 323 Evaluating the Hedge Decision, 323 Comparison of Hedging Techniques, 324 Hedging Policies of MNCs, 325 Limitations of Hedging, 326

Limitation of Hedging an Uncertain Amount, 326 Limitation of Repeated Short-Term Hedging, 326 Hedging Long-Term Transaction Exposure, 328

Long-Term Forward Contract, 328 Parallel Loan, 328 Alternative Hedging Techniques, 329

Leading and Lagging, 329 Cross-Hedging, 329 Currency Diversiﬁcation, 329 Summary, 330 Point Counter-Point: Should an MNC Risk Overhedging?, 330 Self Test, 331 Questions and Applications, 331 Advanced Questions, 334 Discussion in the Boardroom, 338 Running Your Own MNC, 338 Blades, Inc. Case: Management of Transaction Exposure, 338

xi

307

xii

Contents

Small Business Dilemma: Hedging Decisions by the Sports Exports Company, 340 Internet/Excel Exercises, 340 Appendix 11: Nontraditional Hedging Techniques, 341

Chapter 12: Managing Economic Exposure and Translation Exposure

369

Chapter 13: Direct Foreign Investment

370

Motives for Direct Foreign Investment, 370

346

Economic Exposure, 346

Use of Projected Cash Flows to Assess Economic Exposure, 347 How Restructuring Can Reduce Economic Exposure, 348 Issues Involved in the Restructuring Decision, 351 A Case Study in Hedging Economic Exposure, 352

Savor Co.’s Dilemma, 352 Assessment of Economic Exposure, 352 Assessment of Each Unit’s Exposure, 353 Identifying the Source of the Unit’s Exposure, 353 Possible Strategies to Hedge Economic Exposure, 354 Savor’s Hedging Solution, 356 Limitations of Savor’s Optimal Hedging Strategy, 356 Hedging Exposure to Fixed Assets, 356 Managing Translation Exposure, 357

Use of Forward Contracts to Hedge Translation Exposure, 357 Limitations of Hedging Translation Exposure, 358 Governance: Governing the Hedge of Translation Exposure, 359 Summary, 359 Point Counter-Point: Can an MNC Reduce the Impact of Translation Exposure by Communicating, 360 Self Test, 360 Questions and Applications, 361 Advanced Questions, 361 Discussion in the Boardroom, 362 Running Your Own MNC, 362 Blades, Inc. Case: Assessment of Economic Exposure, 363 Small Business Dilemma: Hedging the Sports Exports Company’s Economic Exposure to Exchange Rate Risk, 364 Internet/Excel Exercises, 364 Part 3 Integrative Problem: Exchange Rate Risk Management, 366

Part 4: Long-Term Asset and Liability Management

Revenue-Related Motives, 370 Cost-Related Motives, 371 Governance: Selfish Managerial Motives for DFI, 373

Comparing Beneﬁts of DFI among Countries, 373 Comparing Beneﬁts of DFI over Time, 374 Beneﬁts of International Diversiﬁcation, 375

Diversiﬁcation Analysis of International Projects, 377 Diversiﬁcation among Countries, 379 Decisions Subsequent to DFI, 380 Host Government Views of DFI, 380

Incentives to Encourage DFI, 380 Barriers to DFI, 381 Government-Imposed Conditions to Engage in DFI, 382 Summary, 382 Point Counter-Point: Should MNCs Avoid DFI in Countries with Liberal Child Labor Laws?, 382 Self Test, 383 Questions and Applications, 383 Advanced Questions, 384 Discussion in the Boardroom, 384 Running Your Own MNC, 384 Blades, Inc. Case: Consideration of Direct Foreign Investment, 385 Small Business Dilemma: Direct Foreign Investment Decision by the Sports Exports Company, 386 Internet/Excel Exercises, 386

Chapter 14: Multinational Capital Budgeting Subsidiary versus Parent Perspective, 387

Tax Differentials, 387 Restricted Remittances, 388 Excessive Remittances, 388 Exchange Rate Movements, 388 Summary of Factors, 388 Input for Multinational Capital Budgeting, 389 Multinational Capital Budgeting Example, 391

Background, 391 Analysis, 392 Factors to Consider in Multinational Capital Budgeting, 395

Exchange Rate Fluctuations, 395

387

Contents

Inﬂation, 396 Financing Arrangement, 397 Blocked Funds, 400 Uncertain Salvage Value, 401 Impact of Project on Prevailing Cash Flows, 402 Host Government Incentives, 403 Real Options, 403 Adjusting Project Assessment for Risk, 404

Exchange Rate Effects on the Funds Remitted, 434 Required Return of Acquirer, 434 Other Types of Multinational Restructuring, 434

International Partial Acquisitions, 434 International Acquisitions of Privatized Businesses, 435 International Alliances, 435 International Divestitures, 436 Restructuring Decisions as Real Options, 437

Risk-Adjusted Discount Rate, 404 Sensitivity Analysis, 404 Simulation, 405

Call Option on Real Assets, 437 Put Option on Real Assets, 438

Governance: Controls over International Project Proposals, 406 Summary, 406 Point Counter-Point: Should MNCs Use Forward Rates to Estimate Dollar Cash Flows of Foreign Projects?, 406 Self Test, 407 Questions and Applications, 407 Advanced Questions, 410 Discussion in the Boardroom, 412 Running Your Own MNC, 412 Blades, Inc. Case: Decision by Blades, Inc., to Invest in Thailand, 412 Small Business Dilemma: Multinational Capital Budgeting by the Sports Exports Company, 414 Internet/Excel Exercises, 414 Appendix 14: Incorporating International Tax Laws in Multinational Capital Budgeting, 415

Chapter 15: International Acquisitions

xiii

Summary, 438 Point Counter-Point: Can a Foreign Target Be Assessed Like Any Other Asset?, 439 Self Test, 439 Questions and Applications, 439 Advanced Questions, 440 Discussion in the Boardroom, 443 Running Your Own MNC, 443 Blades, Inc. Case: Assessment of an Acquisition in Thailand, 443 Small Business Dilemma: Multinational Restructuring by the Sports Exports Company, 445 Internet/Excel Exercises, 445

Chapter 16: Country Risk Analysis

446

Why Country Risk Analysis Is Important, 446 Political Risk Factors, 447

422

Background on International Acquisitions, 422

Trends in International Acquisitions, 423 Model for Valuing a Foreign Target, 423 Market Assessment of International Acquisitions, 424 Assessing Potential Acquisitions after the Asian Crisis, 424 Assessing Potential Acquisitions in Europe, 425 Governance: Impact of the Sarbanes-Oxley Act on the Pursuit of Targets, 425

Factors That Affect the Expected Cash Flows of the Foreign Target, 425

Target-Speciﬁc Factors, 425 Country-Speciﬁc Factors, 426 Example of the Valuation Process, 427

International Screening Process, 427 Estimating the Target’s Value, 428 Changes in Valuation over Time, 431 Why Valuations of a Target May Vary among MNCs, 433

Estimated Cash Flows of the Foreign Target, 433

Attitude of Consumers in the Host Country, 447 Actions of Host Government, 447 Blockage of Fund Transfers, 448 Currency Inconvertibility, 448 War, 449 Bureaucracy, 449 Corruption, 449 Financial Risk Factors, 450

Indicators of Economic Growth, 450 Types of Country Risk Assessment, 451

Macroassessment of Country Risk, 451 Microassessment of Country Risk, 452 Techniques to Assess Country Risk, 453

Checklist Approach, 453 Delphi Technique, 453 Quantitative Analysis, 454 Inspection Visits, 454 Combination of Techniques, 454 Measuring Country Risk, 454

Variation in Methods of Measuring Country Risk, 457 Using the Country Risk Rating for Decision Making, 457

xiv

Contents

Comparing Risk Ratings among Countries, 457 Actual Country Risk Ratings across Countries, 457 Incorporating Country Risk in Capital Budgeting, 459

Adjustment of the Discount Rate, 459 Adjustment of the Estimated Cash Flows, 459 How Country Risk Affects Financial Decisions, 462 Governance: Governance over the Assessment of Country Risk, 462

Reducing Exposure to Host Government Takeovers, 463

Use a Short-Term Horizon, 463 Rely on Unique Supplies or Technology, 463 Hire Local Labor, 463 Borrow Local Funds, 463 Purchase Insurance, 464 Use Project Finance, 464

Revising the Capital Structure in Response to Changing Conditions, 488 Interaction between Subsidiary and Parent Financing Decisions, 489

Impact of Increased Debt Financing by the Subsidiary, 490 Impact of Reduced Debt Financing by the Subsidiary, 491 Summary of Interaction between Subsidiary and Parent Financing Decisions, 491 Local versus Global Target Capital Structure, 492

Offsetting a Subsidiary’s High Degree of Financial Leverage, 492 Offsetting a Subsidiary’s Low Degree of Financial Leverage, 492 Limitations in Offsetting a Subsidiary’s Abnormal Degree of Financial Leverage, 492

Summary, 465 Point Counter-Point: Does Country Risk Matter for U.S. Projects?, 465 Self Test, 465 Questions and Applications, 466 Advanced Questions, 467 Discussion in the Boardroom, 469 Running Your Own MNC, 469 Blades, Inc. Case: Country Risk Assessment, 469 Small Business Dilemma: Country Risk Analysis at the Sports Exports Company, 471 Internet/Excel Exercises, 471

Summary, 493 Point Counter-Point: Should the Reduced Tax Rate on Dividends Affect an MNC’s Capital Structure?, 493 Self Test, 494 Questions and Applications, 494 Advanced Questions, 495 Discussion in the Boardroom, 497 Running Your Own MNC, 497 Blades, Inc. Case: Assessment of Cost of Capital, 497 Small Business Dilemma: Multinational Capital Structure Decision at the Sports Exports Company, 499 Internet/Excel Exercises, 499

Chapter 17: Multinational Cost of Capital and Capital Structure 472

Chapter 18: Long-Term Financing

Background on Cost of Capital, 472

Long-Term Financing Decision, 500

Comparing the Costs of Equity and Debt, 472 Cost of Capital for MNCs, 473

Cost-of-Equity Comparison Using the CAPM, 475 Implications of the CAPM for an MNC’s Risk, 476 Costs of Capital across Countries, 477

Country Differences in the Cost of Debt, 477 Country Differences in the Cost of Equity, 478 Combining the Costs of Debt and Equity, 480 Estimating the Cost of Debt and Equity, 480 Using the Cost of Capital for Assessing Foreign Projects, 481

Derive Net Present Values Based on the Weighted Average Cost of Capital, 481 Adjust the Weighted Average Cost of Capital for the Risk Differential, 482 Derive the Net Present Value of the Equity Investment, 482 The MNC’s Capital Structure Decision, 486

Inﬂuence of Corporate Characteristics, 486 Inﬂuence of Country Characteristics, 487

500

Sources of Equity, 500 Sources of Debt, 501 Governance: Stockholder versus Creditor Conflict, 501

Cost of Debt Financing, 501

Measuring the Cost of Financing, 502 Actual Effects of Exchange Rate Movements on Financing Costs, 504 Assessing the Exchange Rate Risk of Debt Financing, 506

Use of Exchange Rate Probabilities, 506 Use of Simulation, 506 Reducing Exchange Rate Risk, 507

Offsetting Cash Inﬂows, 507 Forward Contracts, 508 Currency Swaps, 508 Parallel Loans, 510 Diversifying among Currencies, 514 Interest Rate Risk from Debt Financing, 515

The Debt Maturity Decision, 515

Contents

The Fixed versus Floating Rate Decision, 517 Hedging with Interest Rate Swaps, 517 Plain Vanilla Swap, 517 Summary, 521 Point Counter-Point: Will Currency Swaps Result in Low Financing Costs?, 521 Self Test, 521 Questions and Applications, 522 Advanced Questions, 523 Discussion in the Boardroom, 524 Running Your Own MNC, 524 Blades, Inc. Case: Use of Long-Term Financing, 524 Small Business Dilemma: Long-Term Financing Decision by the Sports Exports Company, 525 Internet/Excel Exercises, 526

Prepayment, 531 Letters of Credit (L/Cs), 531 Drafts, 532 Consignment, 532 Open Account, 532 Trade Finance Methods, 533

Accounts Receivable Financing, 533 Factoring, 533 Letters of Credit (L/Cs), 534 Banker’s Acceptance, 538 Working Capital Financing, 540 Medium-Term Capital Goods Financing (Forfaiting), 541 Countertrade, 541 Agencies That Motivate International Trade, 542

Export-Import Bank of the United States, 542 Private Export Funding Corporation (PEFCO), 544 Overseas Private Investment Corporation (OPIC), 544 Summary, 545 Point Counter-Point: Do Agencies That Facilitate International Trade Prevent Free Trade?, 545 Self Test, 545 Questions and Applications, 545 Advanced Questions, 546

Chapter 20: Short-Term Financing

549

Sources of Short-Term Financing, 549

Short-Term Notes, 549 Commercial Paper, 549 Bank Loans, 549 Internal Financing by MNCs, 550

Why MNCs Consider Foreign Financing, 550

Part 5: Short-Term Asset and Liability Management 529

Payment Methods for International Trade, 530

Discussion in the Boardroom, 546 Running Your Own MNC, 546 Blades, Inc. Case: Assessment of International Trade Financing in Thailand, 546 Small Business Dilemma: Ensuring Payment for Products Exported by the Sports Exports Company, 548 Internet/Excel Exercise, 548

Governance: Governance over Subsidiary Short-Term Financing, 550

Part 4 Integrative Problem: Long-Term Asset and Liability Management, 527

Chapter 19: Financing International Trade

xv

530

Foreign Financing to Offset Foreign Currency Inﬂows, 550 Foreign Financing to Reduce Costs, 551 Determining the Effective Financing Rate, 552 Criteria Considered for Foreign Financing, 553

Interest Rate Parity, 553 The Forward Rate as a Forecast, 554 Exchange Rate Forecasts, 555 Actual Results from Foreign Financing, 558 Financing with a Portfolio of Currencies, 558

Portfolio Diversiﬁcation Effects, 561 Repeated Financing with a Currency Portfolio, 562 Summary, 564 Point Counter-Point: Do MNCs Increase Their Risk When Borrowing Foreign Currencies?, 564 Self Test, 564 Questions and Applications, 565 Advanced Questions, 566 Discussion in the Boardroom, 567 Running Your Own MNC, 567 Blades, Inc. Case: Use of Foreign Short-Term Financing, 567 Small Business Dilemma: Short-Term Financing by the Sports Exports Company, 568 Internet/Excel Exercises, 568

Chapter 21: International Cash Management

569

Multinational Management of Working Capital, 569

Subsidiary Expenses, 569 Subsidiary Revenue, 570 Subsidiary Dividend Payments, 570 Subsidiary Liquidity Management, 570

xvi

Contents

Centralized Cash Management, 571 Governance: Monitoring of MNC Cash Positions, 571

Techniques to Optimize Cash Flows, 572

Accelerating Cash Inﬂows, 572 Minimizing Currency Conversion Costs, 573 Managing Blocked Funds, 575 Managing Intersubsidiary Cash Transfers, 575 Complications in Optimizing Cash Flow, 576

Company-Related Characteristics, 576 Government Restrictions, 576 Characteristics of Banking Systems, 576 Investing Excess Cash, 576

How to Invest Excess Cash, 577 Centralized Cash Management, 577 Determining the Effective Yield, 579 Implications of Interest Rate Parity, 581 Use of the Forward Rate as a Forecast, 581 Use of Exchange Rate Forecasts, 582 Diversifying Cash across Currencies, 585 Dynamic Hedging, 586 Summary, 586 Point Counter-Point: Should Interest Rate Parity Prevent MNCs from Investing in Foreign Currencies?, 587

Self Test, 587 Questions and Applications, 587 Advanced Questions, 588 Discussion in the Boardroom, 589 Running Your Own MNC, 589 Blades, Inc. Case: International Cash Management, 589 Small Business Dilemma: Cash Management at the Sports Exports Company, 590 Internet/Excel Exercises, 590 Appendix 21: Investing in a Portfolio of Currencies, 592 Part 5 Integrative Problem: Short-Term Asset and Liability Management, 596 Final Self Exam, 598

Appendix A: Answers to Self Test Questions, 606 Appendix B: Supplemental Cases, 618 Appendix C: Using Excel to Conduct Analysis, 640 Appendix D: International Investing Project, 647 Appendix E: Discussion in the Boardroom, 650 Glossary, 658 Index, 665

Preface

Businesses evolve into multinational corporations (MNCs) so that they can capitalize on opportunities. Their ﬁ nancial managers must be able to detect opportunities, assess exposure to risk, and manage the risk. The MNCs that are most capable of responding to changes in the international ﬁ nancial environment will be rewarded. The same can be said for the students today who may become the future managers of MNCs.

Intended Market International Financial Management, Ninth Edition, presumes an understanding of basic corporate ﬁ nance. It is suitable for both undergraduate and master’s level courses in international ﬁ nancial management. For master’s courses, the more challenging questions, problems, and cases in each chapter are recommended, along with special projects.

Organization of the Text International Financial Management, Ninth Edition, is organized ﬁ rst to provide a background on the international environment and then to focus on the managerial aspects from a corporate perspective. Managers of MNCs will ﬁ rst need to understand the environment before they can manage within it. The ﬁ rst two parts of the text provide the macroeconomic framework for the text. Part 1 (Chapters 1 through 5) introduces the major markets that facilitate international business. Part 2 (Chapters 6 through 8) describes relationships between exchange rates and economic variables and explains the forces that inﬂuence these relationships. The remainder of the text provides a microeconomic framework, with a focus on the managerial aspects of international ﬁ nancial management. Part 3 (Chapters 9 through 12) explains the measurement and management of exchange rate risk. Part 4 (Chapters 13 through 18) describes the management of long-term assets and liabilities, including motives for direct foreign investment, multinational capital budgeting, country risk analysis, and capital structure decisions. Part 5 (Chapters 19 through 21) concentrates on the MNC’s management of short-term assets and liabilities, including trade ﬁ nancing, other short-term ﬁ nancing, and international cash management. Each chapter is self-contained, so that professors can use classroom time to focus on the more comprehensive topics and rely on the text to cover the other concepts. The management of long-term assets (chapters on direct foreign investment, multinational capital budgeting, multinational restructuring, and country risk analysis) is covered before the management of the long-term liabilities (chapters on capital structure and long-term ﬁ nancing), since the ﬁ nancing decisions are dependent on

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the investments. Yet, concepts are explained with an emphasis of how management of long-term assets and long-term liabilities is integrated. For example, the multinational capital budgeting analysis demonstrates how the feasibility of a foreign project may be dependent on the ﬁ nancing mix. Some professors may prefer to teach the chapters on managing long-term liabilities before the chapters on managing long-term assets. The strategic aspects such as motives for direct foreign investment are covered before the operational aspects such as short-term ﬁ nancing or investment. For professors who prefer to cover the MNC’s management of short-term assets and liabilities before the MNC’s management of long-term assets and liabilities, the parts can be rearranged because they are self-contained. Professors may limit their coverage of chapters in some sections where they believe the text concepts are covered by other courses or do not need additional attention beyond what is in the text. For example, they may limit their attention given to the chapters in Part 2 (Chapters 6 through 8) if students take a course in international economics. If professors focus on the main principles, they may limit their coverage of Chapters 5, 15, 16, and 18. In addition, they may limit their attention given to Chapters 19 through 21 if they believe that the text description does not require elaboration.

Approach of the Text International Financial Management, Ninth Edition, focuses on management decisions that maximize the value of the ﬁ rm. It is designed in recognition of the unique styles of instructors for reinforcing key concepts within a course. Numerous methods of reinforcing these concepts are provided in the text so instructors can select the methods and features that ﬁt their teaching styles. • Part-Opening Diagram. A diagram is provided at the beginning of each part to illustrate how the key concepts covered in that part are related. This offers some information about the organization of chapters in that part. • Objectives. A bulleted list at the beginning of each chapter identiﬁes the key concepts in that chapter. • Examples. The key concepts are thoroughly described in the chapter and supported by examples and illustrations. • Governance. This feature is infused throughout the text in recognition of its increasing popularity and use in explaining concepts in international ﬁ nancial management. • Web Links. Websites that provide useful related information regarding key concepts are identiﬁed. • Summary. A bulleted list at the end of each chapter summarizes the key concepts. This list corresponds to the list of objectives at the beginning of the chapter. • Point/Counter-Point. A controversial issue is introduced, along with opposing arguments, and students are asked to determine which argument is correct and explain why.

• Self Test Questions. A “Self Test” at the end of each chapter challenges students on the key concepts. The answers to these questions are provided in Appendix A.

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• Questions and Applications. Many of the questions and other applications at the end of each chapter test the student’s knowledge of the key concepts in the chapter. • Continuing Case. At the end of each chapter, the continuing case allows students to use the key concepts to solve problems experienced by a ﬁ rm called Blades, Inc. (a producer of roller blades). By working on cases related to the same MNC over a school term, students recognize how an MNC’s decisions are integrated. • Small Business Dilemma. The Small Business Dilemma at the end of each chapter places students in a position where they must use concepts introduced in the chapter to make decisions about a small MNC called Sports Exports Company.

• Internet/Excel Exercises. At the end of each chapter, there are exercises that expose the students to applicable website information, enable the application of Excel to related topics, or a combination of these. For example, students learn how to obtain exchange rate information online and apply Excel to measure the value at risk.

• Integrative Problem. An integrative problem at the end of each part integrates the key concepts of chapters within that part.

• Midterm and Final Examinations. A midterm self-exam is provided at the end of Chapter 8, which focuses on international macro and market conditions (Chapters 1 through 8). A ﬁ nal self-exam is provided at the end of Chapter 21, which focuses on the managerial chapters (Chapters 9 through 21). Students can compare their answers to those in the answer key provided. • Supplemental Cases. Supplemental cases allow students to apply chapter concepts to a speciﬁc situation of an MNC. All supplemental cases are located in Appendix B at the end of the text. • Running Your Own MNC. This project (provided at www.thomsonedu.com/ﬁnance/ madura) allows each student to create a small international business and apply key concepts from each chapter to run the business throughout the school term. • Online Analysis of an MNC. This project (provided at www.thomsonedu.com/ ﬁnance/madura) allows each student to select an MNC and determine how the key concepts from each chapter apply to that MNC throughout the school term.

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• International Investing Project. This project (in Appendix D and also provided at www.thomsonedu.com/ﬁnance/madura) allows students to simulate investing in stocks of MNCs and foreign companies and requires them to assess how the values of these stocks change during the school term in response to international economic conditions. • Discussion in the Boardroom. This project (in Appendix E and also provided at www.thomsonedu.com/ﬁnance/madura) allows students to play the role of managers or board members of a small MNC that they created and make decisions about that ﬁ rm. The variety of end-of-chapter and end-of-part exercises and cases offer many opportunities for students to engage in teamwork, decision making, and communication.

Online Resources The text website at www.thomsonedu.com/ﬁnance/madura provides numerous resources for both students and instructors. • Online Quizzes. Online quizzes reinforce student comprehension of chapter concepts. Answers are provided for immediate feedback, so students know why the correct answer is correct. The quizzes may be sent to the student’s instructor for grading or credit. • References. References to related readings are provided for every chapter. • Internet Links. Links noted in each chapter are provided for easy access with a click.

Other Supplements The following supplements are available to students and instructors:

For the Student • PowerPoint Lecture Slides. A PowerPoint presentation package of lecture slides is available on the text website and the Instructor’s Resource CD as a lecture aid for instructors and a study aid for students. In addition, key ﬁgures from the text are also provided in a separate PowerPoint package, also included on the website and Instructor’s Resource CD. • South-Western Finance Resource Center. The South-Western Finance Resource Center, found at www.thomsonedu.com/ﬁnance, provides unique features, customer service information, and links to book-related websites. It also has resources such as Finance in the News, FinanceLinks Online, Wall Street Analyst Reports from the Gale Group, and more. Learn about valuable products and services to help with your ﬁ nance studies, or contact the ﬁ nance editors at South-Western.

For the Instructor • Instructor’s Manual. The Instructor’s Manual contains the chapter theme, topics to stimulate class discussion, and answers to end-of-chapter Questions, Case Problems, Continuing Cases (Blades, Inc.), Small Business Dilemmas, Integrative Problems, and Supplemental Cases. The Instructor’s Manual is available on the text website and the Instructor’s Resource CD. • Test Bank. An expanded Test Bank contains a large set of questions in multiplechoice or true/false format, including content questions as well as problems. The Test Bank is available on the text website and the Instructor’s Resource CD.

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• ExamView™ Computerized Testing. The ExamView computerized testing program contains all of the questions in the Test Bank. ExamView is an easy-to-use test creation software compatible with Microsoft Windows. Instructors can add or edit questions, instructions, and answers and select questions by previewing them on the screen. Instructors can also create and administer quizzes online, whether over the Internet, a local area network (LAN), or a wide area network (WAN). • PowerPoint Presentation Slides. Revised for this edition, these PowerPoint slides are intended to enhance lectures and provide a guide for student note-taking. Versions 1 and 2, the Basic Lecture Slides and the Expanded Lecture Slides, can be downloaded from the text website. Version 3 and Enhanced PowerPoint Lecture Slides are available on the CD-ROM. • South-Western Finance Resource Center. The South-Western Finance Resource Center, found at www.thomsonedu.com/ﬁnance, provides unique features, including Finance in the News, FinanceLinks Online, Wall Street Analysts Reports, the Digital Finance Case Library, and more, as well as customer service information and relevant product information and links. You may learn how to become an author with South-Western, request review copies, contact the ﬁ nance editors, register for Thomson Investors Network, and more. • Thomson Investors Network. This offer is complimentary to adopters! Instructors using International Financial Management, Ninth Edition, may receive a complimentary password to Thomson Investors Network. This website provides individual investors with a wealth of information and tools, including portfoliotracking software, live stock quotes, and company and industry reports. Contact your South-Western sales rep for more information about this offer.

Acknowledgments Several people have contributed to this textbook. First, the motivation to write the textbook was primarily due to encouragement by professors Robert L. Conn (Miami University of Ohio), E. Joe Nosari and William Schrode (Florida State University), Anthony E. Scaperlanda (Northern Illinois University), and Richard A. Zuber (University of North Carolina at Charlotte). Many of the revisions and expanded sections contained in this edition are due to comments and suggestions from students who used previous editions. In addition, many professors reviewed various editions of the text and had a major inﬂuence on its content and organization. All are acknowledged in alphabetical order: Raj Aggarwal, John Carroll University Alan Alford, Northeastern University H. David Arnold, Auburn University Robert Aubey, University of Wisconsin Bruce D. Bagamery, Central Washington University James C. Baker, Kent State University Gurudutt Baliga, University of Delaware Laurence J. Belcher, Stetson University Richard Benedetto, Merrimack College Bharat B. Bhalla, Fairﬁeld University Rahul Bishnoi, Hofstra University Rita Biswas, State University of New York–Albany Steve Borde, University of Central Florida Sarah Bryant, George Washington University

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Francisco Carrada-Bravo, American Graduate School of International Management Andreas C. Christoﬁ, Azusa Paciﬁc University Ronnie Clayton, Jacksonville State University Alan Cook, Baylor University W. P. Culbertson, Louisiana State University Maria deBoyrie, New Mexico State University Andrea L. DeMaskey, Villanova University Mike Dosal, SunTrust Bank (Orlando) Robert Driskill, Ohio State University Anne M. Drougas, Dominican University Milton Esbitt, Dominican University Larry Fauver, University of Miami Paul Fenton, Bishop’s University Robert G. Fletcher, California State University–Bakersﬁeld Stuart Fletcher, Appalachian State University Jennifer Foo, Stetson University Robert D. Foster, American Graduate School of International Management Hung-Gay Fung, University of Baltimore Juli-Ann E. Gasper, Texas A&M University Farhad F. Ghannadian, Mercer University Joseph F. Greco, California State University–Fullerton Deborah W. Gregory, Bentley College Nicholas Gressis, Wright State University Indra Guertler, Babson College Ann M. Hackert, Idaho State University John M. Harris, Jr., Clemson University Andrea J. Heuson, University of Miami Ghassem Homaifar, Middle Tennessee State University James A. Howard, University of Maryland Nathaniel Jackendoff, Temple University Pankaj Jain, University of Memphis Kurt R. Jesswein, Texas A&M International Steve A. Johnson, University of Texas–El Paso Manuel L. Jose, University of Akron Rauv Kalra, Morehead State University Ho-Sang Kang, University of Texas–Dallas Frederick J. Kelly, Seton Hall University Robert Kemp, University of Virginia Coleman S. Kendall, University of Illinois–Chicago Dara Khambata, American University Doseong Kim, University of Akron Elinda F. Kiss, University of Maryland Thomas J. Kopp, Siena College Suresh Krishman, Pennsylvania State University Merouane Lakehal-Ayat, St. John Fisher College Boyden E. Lee, New Mexico State University Jeong W. Lee, University of North Dakota Richard Lindgren, Graceland University Charmen Loh, Rider University Carl Luft, DePaul University K. Christopher Ma, KCM Investment Co. Richard D. Marcus, University of Wisconsin–Milwaukee

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xxiii

Anna D. Martin, Fairﬁeld University Leslie Mathis, University of Memphis Ike Mathur, Southern Illinois University Wendell McCulloch, Jr., California State University–Long Beach Carl McGowan, University of Michigan–Flint Fraser McHafﬁe, Marietta College Stuart Michelson, Stetson University Penelope E. Nall, Gardner-Webb University Vivian Okere, Providence College Edward Omberg, San Diego State University Prasad Padmanabhan, San Diego State University Ali M. Parhizgari, Florida International University Anne Perry, American University Larry Prather, East Tennessee State University Abe Qastin, Lakeland College Frances A. Quinn, Merrimack College S. Ghon Rhee, University of Rhode Island William J. Rieber, Butler University Ashok Robin, Rochester Institute of Technology Tom Rosengarth, Westminster College Kevin Scanlon, Notre Dame University Jacobus T. Severiens, Kent State University Peter Sharp, California State University–Sacramento Dilip K. Shome, Virginia Tech University Joseph Singer, University of Missouri–Kansas City Naim Sipra, University of Colorado–Denver Jacky So, Southern Illinois University–Edwardsville Luc Soenen, California Polytechnic State University–San Luis Obispo Ahmad Sohrabian, California State Polytechnic University–Pomona Caroline Spencer, Dowling College Angelo Tarallo, Ramapo College Amir Tavakkol, Kansas State University Stephen G. Timme, Georgia State University Eric Tsai, Temple University C. Joe Ueng, University of St. Thomas Mahmoud S. Wahab, University of Hartford Ralph C. Walter III, Northeastern Illinois University Elizabeth Webbink, Rutgers University Ann Marie Whyte, University of Central Florida Marilyn Wiley, Florida Atlantic University Rohan Williamson, Georgetown University Larry Wolken, Texas A&M University Glenda Wong, De Paul University Mike Yarmuth, Sullivan University Yeomin Yoon, Seton Hall University David Zalewski, Providence College Emilio Zarruk, Florida Atlantic University Stephen Zera, California State University–San Marcos Beyond the suggestions provided by reviewers, this edition also beneﬁted from the input of many people who I met outside the United States and who were willing to share their views about international ﬁ nancial management. In addition, I thank my colleagues at Florida Atlantic University, including John Bernardin, Antoine

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Giannetti, and Kim Gleason. I also thank Joel Harper (Oklahoma State University), Victor Kalafa (Cross Country Inc.), Thanh Ngo (Florida Atlantic University), Oliver Schnusenberg (University of North Florida), and Alan Tucker (Pace University) for their suggestions. I acknowledge the help and support from the people at South-Western, including Mike Reynolds (Executive Editor), Jason Krall (Marketing Manager), Mike Guendelsberger (Developmental Editor), Adele Scholtz (Senior Editorial Assistant), and Angela Glassmeyer (Senior Marketing Coordinator). A special thanks is due to Scott Dillon (Associate Content Project Manager) and Pat Lewis (Copy Editor) for their efforts to ensure a quality ﬁ nal product. Finally, I wish to thank my wife, Mary, and my parents, Arthur and Irene Madura, for their moral support. Jeff Madura Florida Atlantic University

About the Author

Jeff Madura is the SunTrust Bank Professor of Finance at Florida Atlantic University. He has written several textbooks, including Financial Markets and Institutions. His research on international ﬁ nance has been published in numerous journals, including Journal of Financial and Quantitative Analysis, Journal of Money, Credit and Banking, Journal of Banking and Finance, Financial Management, Journal of International Money and Finance, Journal of Financial Research, Financial Review, Journal of Multinational Financial Management, and Global Finance Journal. He has received awards for excellence in teaching and research and has served as a consultant for international banks, securities ﬁ rms, and other multinational corporations. He has served as a director for the Southern Finance Association and Eastern Finance Association and has been president of the Southern Finance Association.

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Part 1: The International Financial Environment Part 1 (Chapters 1 through 5) provides an overview of the multinational corporation (MNC) and the environment in which it operates. Chapter 1 explains the goals of the MNC, along with the motives and risks of international business. Chapter 2 describes the international flow of funds between countries. Chapter 3 describes the international financial markets and how these markets facilitate ongoing operations. Chapter 4 explains how exchange rates are determined, while Chapter 5 provides background on the currency futures and options markets. Managers of MNCs must understand the international environment described in these chapters in order to make proper decisions.

Multinational Corporation (MNC)

Foreign Exchange Markets

Dividend Remittance and Financing Exporting and Importing

Product Markets

Investing and Financing

Subsidiaries

International Financial Markets

1: Multinational Financial Management: An Overview Multinational corporations (MNCs) are deﬁned as ﬁrms that engage in some form of international business. Their managers conduct international ﬁnancial management, which involves international investing and ﬁnancing decisions that are intended to maximize the value of the MNC. The goal of their managers is to maximize the value of the ﬁrm, which is similar to the goal of managers employed by domestic companies. Initially, ﬁrms may merely attempt to export products to a particular country or import supplies from a foreign manufacturer. Over time, however, many of them recognize additional foreign opportunities and eventually establish subsidiaries in foreign countries. Dow Chemical, IBM, Nike, and many other ﬁrms have more than half of their assets in foreign countries. Some businesses, such as ExxonMobil, Fortune Brands, and ColgatePalmolive, commonly generate more than half of their sales in foreign countries. A prime example is the Coca-Cola Co., which distributes its products in more than 160 countries and uses 40 different currencies. Over 60 percent of its total annual operating income is typically generated outside the United States. Even smaller U.S. ﬁrms commonly generate more than 20 percent of their sales in foreign markets, including AMSCO International (Pennsylvania), Ferro (Ohio), Interlake (Illinois), Medtronic (Minnesota), Sybron

(Wisconsin), and Synoptics (California). These U.S. ﬁrms that conduct international business tend to focus on the niches that have made them successful in the United States. Seventy-ﬁve percent of U.S. ﬁrms that export have fewer than 100 employees. International ﬁnancial management is important even to companies that have no international business because these companies must recognize how their foreign competitors will be affected by movements in exchange rates, foreign interest rates, labor costs, and inﬂation. Such economic characteristics can affect the foreign competitors’ costs of production and pricing policies. This chapter provides background on the goals of an MNC and the potential risk and returns from engaging in international business. The specific objectives of this chapter are to: ■ identify the management goal and organizational

structure of the MNC, ■ describe the key theories that justify international

business, ■ explain the common methods used to conduct inter-

national business, and ■ provide a model for valuing the MNC.

Managing the MNC The commonly accepted goal of an MNC is to maximize shareholder wealth. Managers employed by the MNC are expected to make decisions that will maximize the stock price and therefore serve the shareholders. Some publicly traded MNCs based outside the United States may have additional goals, such as satisfying their respective governments, banks, or employees. However, these MNCs now place more emphasis on satisfying shareholders so that they can more easily obtain funds from shareholders to support their operations. There are even some ﬁ rms in Russia, Poland, and Slovenia that have issued stock to investors and are focused on satisfying their shareholders. Our focus in this text is on the U.S.-based MNC and its shareholders, but the concepts commonly apply to MNCs based in other countries. 2

Chapter 1: Multinational Financial Management: An Overview

3

The focus of this text is on MNCs whose parents wholly own any foreign subsidiaries, which means that the U.S. parent is the sole owner of the subsidiaries. This is the most common form of ownership of U.S.-based MNCs, and it enables ﬁ nancial managers throughout the MNC to have a single goal of maximizing the value of the entire MNC instead of maximizing the value of any particular foreign subsidiary.

Facing Agency Problems Managers of an MNC may make decisions that conﬂ ict with the ﬁ rm’s goal to maximize shareholder wealth. For example, a decision to establish a subsidiary in one location versus another may be based on the location’s appeal to a particular manager rather than on its potential beneﬁts to shareholders. A decision to expand a subsidiary may be motivated by a manager’s desire to receive more compensation rather than to enhance the value of the MNC. This conﬂ ict of goals between a ﬁ rm’s managers and shareholders is often referred to as the agency problem. The costs of ensuring that managers maximize shareholder wealth (referred to as agency costs) are normally larger for MNCs than for purely domestic ﬁ rms for several reasons. First, MNCs with subsidiaries scattered around the world may experience larger agency problems because monitoring managers of distant subsidiaries in foreign countries is more difﬁcult. Second, foreign subsidiary managers raised in different cultures may not follow uniform goals. Third, the sheer size of the larger MNCs can also create large agency problems. Fourth, some non-U.S. managers tend to downplay the short-term effects of decisions, which may result in decisions for foreign subsidiaries of the U.S.-based MNCs that are inconsistent with maximizing shareholder wealth.

Parent Control of Agency Problems. The parent corporation of an MNC may be able to prevent agency problems with proper governance. It should clearly communicate the goals for each subsidiary to ensure that all subsidiaries focus on maximizing the value of the MNC rather than their respective subsidiary values. The parent can oversee the subsidiary decisions to check whether the subsidiary managers are satisfying the MNC’s goals. The parent can also implement compensation plans that reward the subsidiary managers who satisfy the MNC’s goals. A common incentive is to provide managers with the MNC’s stock (or options to buy the stock at a ﬁ xed price) as part of their compensation, so that they beneﬁt directly from a higher stock price when they make decisions that enhance the MNC’s value. Corporate Control of Agency Problems. There are also various forms of corporate control that can help prevent agency problems and therefore ensure that managers make decisions to satisfy the MNC’s shareholders. If the MNC’s managers make poor decisions that reduce its value, another ﬁ rm may be able to acquire it at a low price and will likely remove the weak managers. In addition, institutional investors such as mutual funds or pension funds that have large holdings of an MNC’s stock have some inﬂuence over management because they can complain to the board of directors if managers are making poor decisions. They may attempt to enact changes in a poorly performing MNC, such as the removal of high-level managers or even board members. The institutional investors may even work together when demanding changes in an MNC because an MNC would not want to lose all of its major shareholders. How SOX Improved Corporate Governance of MNCs One limitation of the corporate control process is that investors rely on the reporting by the firm’s managers for information. If managers are serving themselves rather than the investors, they may exaggerate their performance. There are many well-known examples (such as Enron and WorldCom) in which large MNCs were able to alter their financial reporting so that investors would not be aware of their financial problems.

GOVE ER RN NA AN NC CE E

4

Part 1: The International Financial Environment Enacted in 2002, the Sarbanes-Oxley Act (SOX) ensures a more transparent process for managers to report on the productivity and financial condition of their firm. It requires firms to implement an internal reporting process that can be easily monitored by executives and the board of directors. Some of the common methods used by MNCs to improve their internal control process are: • Establishing a centralized database of information • Ensuring that all data are reported consistently among subsidiaries • Implementing a system that automatically checks data for unusual discrepancies relative to norms • Speeding the process by which all departments and all subsidiaries have access to the data that they need • Making executives more accountable for financial statements by personally verifying their accuracy These systems made it easier for a firm’s board members to monitor the financial reporting process. Therefore, SOX reduced the likelihood that managers of a firm can manipulate the reporting process and therefore improved the accuracy of financial information for existing and prospective investors. ■

Management Structure of an MNC The magnitude of agency costs can vary with the management style of the MNC. A centralized management style, as illustrated in the top section of Exhibit 1.1, can reduce agency costs because it allows managers of the parent to control foreign subsidiaries and therefore reduces the power of subsidiary managers. However, the parent’s managers may make poor decisions for the subsidiary if they are not as informed as subsidiary managers about ﬁ nancial characteristics of the subsidiary. Alternatively, an MNC can use a decentralized management style, as illustrated in the bottom section of Exhibit 1.1. This style is more likely to result in higher agency costs because subsidiary managers may make decisions that do not focus on maximizing the value of the entire MNC. Yet, this style gives more control to those managers who are closer to the subsidiary’s operations and environment. To the extent that subsidiary managers recognize the goal of maximizing the value of the overall MNC and are compensated in accordance with that goal, the decentralized management style may be more effective. Given the obvious tradeoff between centralized and decentralized management styles, some MNCs attempt to achieve the advantages of both styles. That is, they allow subsidiary managers to make the key decisions about their respective operations, but the parent’s management monitors the decisions to ensure that they are in the best interests of the entire MNC.

How the Internet Facilitates Management Control. The Internet is making it easier for the parent to monitor the actions and performance of its foreign subsidiaries. The parent of Jersey, Inc., has subsidiaries in Australia and Italy. The subsidiaries are in different time zones, so communicating frequently by phone is inconvenient and expensive. In addition, financial reports and designs of new products or plant sites cannot be easily communicated over the phone. The Internet allows the foreign subsidiaries to e-mail updated information in a standardized format to avoid language problems and to send images of financial reports and product designs. The parent can easily track inventory, sales, expenses, and earnings of each subsidiary on a weekly or monthly basis. Thus, the use of the Internet can reduce agency costs due to international business. ■

E X A M P L E

Chapter 1: Multinational Financial Management: An Overview Exhibit 1.1

5

Management Styles of MNCs

Centralized Multinational Financial Management Cash Management at Subsidiary A

Financial Managers of Parent

Inventory and Accounts Receivable Management at Subsidiary A

Financing at Subsidiary A

Cash Management at Subsidiary B

Inventory and Accounts Receivable Management at Subsidiary B

Capital Expenditures at Subsidiary A

Capital Expenditures at Subsidiary B

Financing at Subsidiary B

Decentralized Multinational Financial Management Cash Management at Subsidiary A

Financial Managers of Subsidiary A

Financial Managers of Subsidiary B

Inventory and Accounts Receivable Management at Subsidiary A

Financing at Subsidiary A

Cash Management at Subsidiary B

Inventory and Accounts Receivable Management at Subsidiary B

Capital Expenditures at Subsidiary A

Capital Expenditures at Subsidiary B

Financing at Subsidiary B

Why Firms Pursue International Business The commonly held theories as to why ﬁ rms become motivated to expand their business internationally are (1) the theory of comparative advantage, (2) the imperfect markets theory, and (3) the product cycle theory. The three theories overlap to a

6

Part 1: The International Financial Environment

degree and can complement each other in developing a rationale for the evolution of international business.

Theory of Comparative Advantage Multinational business has generally increased over time. Part of this growth is due to the heightened realization that specialization by countries can increase production efﬁciency. Some countries, such as Japan and the United States, have a technology advantage, while other countries, such as Jamaica, Mexico, and South Korea, have an advantage in the cost of basic labor. Since these advantages cannot be easily transported, countries tend to use their advantages to specialize in the production of goods that can be produced with relative efﬁciency. This explains why countries such as Japan and the United States are large producers of computer components, while countries such as Jamaica and Mexico are large producers of agricultural and handmade goods. MNCs such as Oracle, Intel, and IBM have grown substantially in foreign countries because of their technology advantage. When a country specializes in some products, it may not produce other products, so trade between countries is essential. This is the argument made by the classical theory of comparative advantage. Comparative advantages allow ﬁ rms to penetrate foreign markets. Many of the Virgin Islands, for example, specialize in tourism and rely completely on international trade for most products. Although these islands could produce some goods, it is more efﬁcient for them to specialize in tourism. That is, the islands are better off using some revenues earned from tourism to import products rather than attempting to produce all the products that they need.

Imperfect Markets Theory If each country’s markets were closed from all other countries, there would be no international business. At the other extreme, if markets were perfect, so that the factors of production (such as labor) were easily transferable, then labor and other resources would ﬂow wherever they were in demand. The unrestricted mobility of factors would create equality in costs and returns and remove the comparative cost advantage, the rationale for international trade and investment. However, the real world suffers from imperfect market conditions where factors of production are somewhat immobile. There are costs and often restrictions related to the transfer of labor and other resources used for production. There may also be restrictions on transferring funds and other resources among countries. Because markets for the various resources used in production are “imperfect,” MNCs such as the Gap and Nike often capitalize on a foreign country’s resources. Imperfect markets provide an incentive for ﬁ rms to seek out foreign opportunities.

Product Cycle Theory One of the more popular explanations as to why ﬁ rms evolve into MNCs is the product cycle theory. According to this theory, ﬁ rms become established in the home market as a result of some perceived advantage over existing competitors, such as a need by the market for at least one more supplier of the product. Because information about markets and competition is more readily available at home, a ﬁ rm is likely to establish itself ﬁ rst in its home country. Foreign demand for the ﬁ rm’s product will initially be accommodated by exporting. As time passes, the ﬁ rm may feel the only way to retain its advantage over competition in foreign countries is to produce the product in foreign markets, thereby reducing its transportation costs. The competition in the foreign markets may increase as other producers become more familiar with the ﬁ rm’s product. The ﬁ rm may develop strategies to prolong the foreign demand for its product. A common approach is to attempt to differentiate the product so that other

Chapter 1: Multinational Financial Management: An Overview

7

competitors cannot offer exactly the same product. These phases of the cycle are illustrated in Exhibit 1.2. As an example, 3M Co. uses one new product to penetrate foreign markets. After entering the market, it expands its product line There is more to the product cycle theory than is summarized here. This discussion merely suggests that, as a ﬁ rm matures, it may recognize additional opportunities outside its home country. Whether the ﬁ rm’s foreign business diminishes or expands over time will depend on how successful it is at maintaining some advantage over its competition. The advantage could represent an edge in its production or ﬁ nancing approach that reduces costs or an edge in its marketing approach that generates and maintains a strong demand for its product.

How Firms Engage in International Business Firms use several methods to conduct international business. The most common methods are these: • International trade • Licensing • Franchising • Joint ventures • Acquisitions of existing operations • Establishing new foreign subsidiaries Each method is discussed in turn, with some emphasis on its risk and return characteristics.

Exhibit 1.2

International Product Life Cycle

1

2

Firm creates product to accommodate local demand.

Firm exports product to accommodate foreign demand.

4a

Firm differentiates product from competitors and/or expands product line in foreign country.

3

4b

Firm establishes foreign subsidiary to establish presence in foreign country and possibly to reduce costs.

or

Firm’s foreign business declines as its competitive advantages are eliminated.

8

Part 1: The International Financial Environment

H T T P : // http://www.ita.doc.gov/td/ industry/otea Outlook of international trade conditions for each of several industries.

International Trade International trade is a relatively conservative approach that can be used by ﬁ rms to penetrate markets (by exporting) or to obtain supplies at a low cost (by importing). This approach entails minimal risk because the ﬁ rm does not place any of its capital at risk. If the ﬁ rm experiences a decline in its exporting or importing, it can normally reduce or discontinue this part of its business at a low cost. Many large U.S.-based MNCs, including Boeing, DuPont, General Electric, and IBM, generate more than $4 billion in annual sales from exporting. Nonetheless, small businesses account for more than 20 percent of the value of all U.S. exports.

How the Internet Facilitates International Trade. Many ﬁ rms use their websites to list the products that they sell, along with the price for each product. This allows them to easily advertise their products to potential importers anywhere in the world without mailing brochures to various countries. In addition, a ﬁ rm can add to its product line or change prices by simply revising its website. Thus, importers need only monitor an exporter’s website periodically to keep abreast of its product information. Firms can also use their websites to accept orders online. Some products such as software can be delivered directly to the importer over the Internet in the form of a ﬁ le that lands in the importer’s computer. Other products must be shipped, but the Internet makes it easier to track the shipping process. An importer can transmit its order for products via e-mail to the exporter. The exporter’s warehouse ﬁ lls orders. When the warehouse ships the products, it can send an e-mail message to the importer and to the exporter’s headquarters. The warehouse may even use technology to monitor its inventory of products so that suppliers are automatically notiﬁed to send more supplies once the inventory is reduced to a speciﬁc level. If the exporter uses multiple warehouses, the Internet allows them to work as a network so that if one warehouse cannot ﬁ ll an order, another warehouse will.

Licensing Licensing obligates a ﬁ rm to provide its technology (copyrights, patents, trademarks,

or trade names) in exchange for fees or some other speciﬁed beneﬁts. For example, AT&T and Verizon Communications have licensing agreements to build and operate parts of India’s telephone system. Sprint Nextel Corp. has a licensing agreement to develop telecommunications services in the United Kingdom. Eli Lilly & Co. has a licensing agreement to produce drugs for Hungary and other countries. IGA, Inc., which operates more than 3,000 supermarkets in the United States, has a licensing agreement to operate supermarkets in China and Singapore. Licensing allows ﬁ rms to use their technology in foreign markets without a major investment in foreign countries and without the transportation costs that result from exporting. A major disadvantage of licensing is that it is difﬁcult for the ﬁ rm providing the technology to ensure quality control in the foreign production process.

How the Internet Facilitates Licensing. Some ﬁ rms with an international reputation use their brand name to advertise products over the Internet. They may use manufacturers in foreign countries to produce some of their products subject to their speciﬁcations. Springs, Inc., has set up a licensing agreement with a manufacturer in the Czech Republic. When Springs receives orders for its products from customers in Eastern Europe, it relies on this manufacturer to produce and deliver the products ordered. This expedites the delivery process and may even allow Springs to have the products manufactured at a lower cost than if it produced them itself. ■

E X A M P L E

Chapter 1: Multinational Financial Management: An Overview

9

Franchising Franchising obligates a ﬁ rm to provide a specialized sales or service strategy, support assistance, and possibly an initial investment in the franchise in exchange for periodic fees. For example, McDonald’s, Pizza Hut, Subway Sandwiches, Blockbuster Video, and Dairy Queen have franchises that are owned and managed by local residents in many foreign countries. Like licensing, franchising allows ﬁ rms to penetrate foreign markets without a major investment in foreign countries. The recent relaxation of barriers in foreign countries throughout Eastern Europe and South America has resulted in numerous franchising arrangements.

Joint Ventures A joint venture is a venture that is jointly owned and operated by two or more ﬁ rms. Many ﬁ rms penetrate foreign markets by engaging in a joint venture with ﬁ rms that reside in those markets. Most joint ventures allow two ﬁ rms to apply their respective comparative advantages in a given project. For example, General Mills, Inc., joined in a venture with Nestlé SA, so that the cereals produced by General Mills could be sold through the overseas sales distribution network established by Nestlé. Xerox Corp. and Fuji Co. (of Japan) engaged in a joint venture that allowed Xerox Corp. to penetrate the Japanese market and allowed Fuji to enter the photocopying business. Sara Lee Corp. and AT&T have engaged in joint ventures with Mexican ﬁ rms to gain entry to Mexico’s markets. Joint ventures between automobile manufacturers are numerous, as each manufacturer can offer its technological advantages. General Motors has ongoing joint ventures with automobile manufacturers in several different countries, including Hungary and the former Soviet states.

Acquisitions of Existing Operations Firms frequently acquire other ﬁ rms in foreign countries as a means of penetrating foreign markets. For example, American Express recently acquired ofﬁces in London, while Procter & Gamble purchased a bleach company in Panama. Acquisitions allow ﬁ rms to have full control over their foreign businesses and to quickly obtain a large portion of foreign market share. Home Depot acquired the second largest home improvement business in Mexico. This acquisition was Home Depot’s first in Mexico, but allowed it to expand its business after establishing name recognition there. Home Depot is expanding in Mexico just as it did in Canada throughout the 1990s. ■

E X A M P L E

An acquisition of an existing corporation is subject to the risk of large losses, however, because of the large investment required. In addition, if the foreign operations perform poorly, it may be difﬁcult to sell the operations at a reasonable price. Some ﬁ rms engage in partial international acquisitions in order to obtain a stake in foreign operations. This requires a smaller investment than full international acquisitions and therefore exposes the ﬁ rm to less risk. On the other hand, the ﬁ rm will not have complete control over foreign operations that are only partially acquired.

Establishing New Foreign Subsidiaries Firms can also penetrate foreign markets by establishing new operations in foreign countries to produce and sell their products. Like a foreign acquisition, this method requires a large investment. Establishing new subsidiaries may be preferred to foreign acquisitions because the operations can be tailored exactly to the ﬁ rm’s needs. In addition, a smaller investment may be required than would be needed to purchase existing operations. However, the ﬁ rm will not reap any rewards from the investment until the subsidiary is built and a customer base established.

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Part 1: The International Financial Environment

Summary of Methods The methods of increasing international business extend from the relatively simple approach of international trade to the more complex approach of acquiring foreign ﬁ rms or establishing new subsidiaries. Any method of increasing international business that requires a direct investment in foreign operations normally is referred to as a direct foreign investment (DFI). International trade and licensing usually are not considered to be DFI because they do not involve direct investment in foreign operations. Franchising and joint ventures tend to require some investment in foreign operations, but to a limited degree. Foreign acquisitions and the establishment of new foreign subsidiaries require substantial investment in foreign operations and represent the largest portion of DFI. Many MNCs use a combination of methods to increase international business. Motorola and IBM, for example, have substantial direct foreign investment but also derive some of their foreign revenue from various licensing agreements, which require less DFI to generate revenue. The evolution of Nike began in 1962 when Phil Knight, a business student at Stanford’s business school, wrote a paper on how a U.S. firm could use Japanese technology to break the German dominance of the athletic shoe industry in the United States. After graduation, Knight visited the Unitsuka Tiger shoe company in Japan. He made a licensing agreement with that company to produce a shoe that he sold in the United States under the name Blue Ribbon Sports (BRS). In 1972, Knight exported his shoes to Canada. In 1974, he expanded his operations into Australia. In 1977, the firm licensed factories in Taiwan and Korea to produce athletic shoes and then sold the shoes in Asian countries. In 1978, BRS became Nike, Inc., and began to export shoes to Europe and South America. As a result of its exporting and its direct foreign investment, Nike’s international sales reached $1 billion by 1992 and were more than $7 billion by 2007. ■

E X A M P L E

The manner by which an MNC’s international business affects its cash ﬂows is illustrated in Exhibit 1.3. In general, the cash outﬂows associated with international business by the U.S. parent are to pay for imports, to comply with its international arrangements, or to support the creation or expansion of foreign subsidiaries. Conversely, it will receive cash ﬂows in the form of payment for its exports, fees for the services it provides within international arrangements, and remitted funds from the foreign subsidiaries. The ﬁ rst diagram in this exhibit represents a ﬁ rm that has only domestic business activities. The second diagram reﬂects an MNC that engages in international trade. Thus, its international cash ﬂows result from either paying for imported supplies or receiving payment in exchange for products that it exports. The third diagram reﬂects an MNC that engages in some international arrangements (which can include international licensing, franchising, or joint ventures). Any of these international arrangements can require cash outﬂows by the MNC in foreign countries to comply with the arrangement, such as the expenses incurred from transferring technology or funding partial investment in a franchise or joint venture. These arrangements generate cash ﬂows to the MNC in the form of fees for services (such as technology or support assistance) it provides. The fourth diagram reﬂects an MNC that engages in direct foreign investment. This type of MNC has one or more foreign subsidiaries. There can be cash outﬂows from the U.S. parent to its foreign subsidiaries in the form of invested funds to help ﬁ nance the operations of the foreign subsidiaries. There are also cash ﬂows from the foreign subsidiaries to the U.S. parent in the form of remitted earnings and fees for services provided by the parent, which can all be classiﬁed as remitted funds from the foreign subsidiaries.

Chapter 1: Multinational Financial Management: An Overview Exhibit 1.3

11

Cash Flow Diagrams for MNCs

U.S.-based MNC Cash Inﬂows Received from Selling Products U.S. Customers Domestic Business Activities

Cash Outﬂows to Pay Wages U.S. Employees Cash Outﬂows to Buy Supplies and Materials U.S. Businesses

Cash Inﬂows from Selling Products International Trade Activities

Licensing, Franchising, and Joint Venture Activities

Foreign Importers Cash Outﬂows to Buy Supplies and Materials Foreign Exporters

Cash Inﬂows from Services Provided Cash Outﬂows for Services Received

Cash Inﬂows from Remitted Earnings Investment in Foreign Subsidiaries

Cash Outﬂows to Provide Financing for Foreign Subsidiaries

Foreign Firms

Foreign Subsidiaries of U.S.-based MNC

Valuation Model for an MNC The value of an MNC is relevant to its shareholders and its debtholders. When managers make decisions that maximize the value of the ﬁ rm, they maximize shareholder wealth (assuming that the decisions are not intended to maximize the wealth of debtholders at the expense of shareholders). Since international ﬁ nancial management should be conducted with the goal of increasing the value of the MNC, it is useful to review some basics of valuation. There are numerous methods of valuing an MNC, and some methods will lead to the same valuation. The valuation method described in this section can be used to understand the key factors that affect an MNC’s value in a general sense.

Domestic Model Before modeling an MNC’s value, consider the valuation of a purely domestic ﬁ rm that does not engage in any foreign transactions. The value (V) of a purely domestic ﬁ rm in the United States is commonly speciﬁed as the present value of its expected

12

Part 1: The International Financial Environment

cash ﬂows, where the discount rate used reﬂects the weighted average cost of capital and represents the required rate of return by investors: n 3 E 1 CF$,t 2 4 V5 ae f 11 1 k2t t51

where E(CF $,t) represents expected cash ﬂows to be received at the end of period t, n represents the number of periods into the future in which cash ﬂows are received, and k represents the required rate of return by investors. The dollar cash ﬂows in period t represent funds received by the ﬁ rm minus funds needed to pay expenses or taxes, or to reinvest in the ﬁ rm (such as an investment to replace old computers or machinery). The expected cash ﬂows are estimated from knowledge about various existing projects as well as other projects that will be implemented in the future. A ﬁ rm’s decisions about how it should invest funds to expand its business can affect its expected future cash ﬂows and therefore can affect the ﬁ rm’s value. Holding other factors constant, an increase in expected cash ﬂows over time should increase the value of the ﬁ rm. The required rate of return (k) in the denominator of the valuation equation represents the cost of capital (including both the cost of debt and the cost of equity) to the ﬁ rm and is essentially a weighted average of the cost of capital based on all of the ﬁ rm’s projects. As the ﬁ rm makes decisions that affect its cost of debt or its cost of equity for one or more projects, it affects the weighted average of its cost of capital and therefore affects the required rate of return. For example, if the ﬁ rm’s credit rating is suddenly lowered, its cost of capital will probably increase and so will its required rate of return. Holding other factors constant, an increase in the ﬁ rm’s required rate of return will reduce the value of the ﬁ rm because expected cash ﬂows must be discounted at a higher interest rate. Conversely, a decrease in the ﬁ rm’s required rate of return will increase the value of the ﬁ rm because expected cash ﬂows are discounted at a lower required rate of return.

Valuing International Cash Flows An MNC’s value can be speciﬁed in the same manner as a purely domestic ﬁ rm’s. However, consider that the expected cash ﬂows generated by a U.S.-based MNC’s parent in period t may be coming from various countries and may therefore be denominated in different foreign currencies. The foreign currency cash ﬂows will be converted into dollars. Thus, the expected dollar cash ﬂows to be received at the end of period t are equal to the sum of the products of cash ﬂows denominated in each currency j times the expected exchange rate at which currency j could be converted into dollars by the MNC at the end of period t. E 1 CF$,t 2 5 a 3 E 1 CFj,t 2 3 E 1 Sj,t 2 4 m

j51

where CFj,t represents the amount of cash ﬂow denominated in a particular foreign currency j at the end of period t, and Sj,t represents the exchange rate at which the foreign currency (measured in dollars per unit of the foreign currency) can be converted to dollars at the end of period t.

Valuation of an MNC That Uses Two Currencies. An MNC that does business in two currencies could measure its expected dollar cash ﬂows in any period by multiplying the expected cash ﬂow in each currency times the expected exchange rate at which that currency could be converted to dollars and then summing those two products. If the ﬁ rm does not use various techniques (discussed later in the text) to hedge its transactions in foreign currencies, the expected exchange rate in a given period would be used in the valuation equation to estimate the corresponding expected exchange rate at which the foreign currency can be converted into dollars in

Chapter 1: Multinational Financial Management: An Overview

13

that period. Conversely, if the MNC hedges these transactions, the exchange rate at which it can hedge would be used in the valuation equation. It may help to think of an MNC as a portfolio of currency cash ﬂows, one for each currency in which it conducts business. The expected dollar cash ﬂows derived from each of those currencies can be combined to determine the total expected dollar cash ﬂows in each future period. The present value of those cash ﬂows serves as the estimate of the MNC’s value. It is easier to derive an expected dollar cash ﬂow value for each currency before combining the cash ﬂows among currencies within a given period, because each currency’s cash ﬂow amount must be converted to a common unit (the dollar) before combining the amounts. Carolina Co. has expected cash flows of $100,000 from local business and 1 million Mexican pesos from business in Mexico at the end of period t. Assuming that the peso’s value is expected to be $.09, the expected dollar cash flows are:

E X A M P L E

E 1 CF$,t 2 5 a 3 E 1 CFj,t 2 3 E 1 Sj,t 2 4 m

j51

5 1 $100,000 2 1 3 1,000,000 pesos 3 1 $.09 2 4 5 1 $100,000 2 1 1 $90,000 2 5 $190,000.

The cash flows of $100,000 from U.S. business were already denominated in U.S. dollars and therefore did not have to be converted. ■

Valuation of an MNC That Uses Many Currencies. Carolina’s dollar cash ﬂows at the end of every period in the future can be estimated in the same manner. Then, its value can be measured by determining the present value of the expected dollar cash ﬂows, which is the sum of the discounted dollar cash ﬂows that are expected in all future periods. If an MNC had transactions involving 40 currencies, the same process could be used. The expected dollar cash ﬂows for each of the 40 currencies would be estimated separately for each future period. The expected dollar cash ﬂows for each of the 40 currencies within each period could then be combined to derive the total dollar cash ﬂows per period. Finally, the cash ﬂows in each period would be discounted to derive the value of the MNC. The general formula for the dollar cash ﬂows received by an MNC in any particular period can be written as: E 1 CF$,t 2 5 a 3 E 1 CFj,t 2 3 E 1 Sj,t 2 4 m

j51

The value of an MNC can be more clearly differentiated from the value of a purely domestic ﬁ rm by substituting the expression [E(CFj,t) E(Sj,t)] for E(CF $,t) in the valuation model, as shown here: a 3 E 1 CFj,t 2 3 E 1 Sj,t 2 4 m

n

V5 ad t51

j51

11 1 k2t

t

where CFj,t represents the cash ﬂow denominated in a particular currency (including dollars), and Sj,t represents the exchange rate at which the MNC can convert the foreign currency at the end of period t. Thus, the value of an MNC should be favorably affected by expectations of an increase in CFj,t or Sj,t. Only those cash ﬂows that are to be received by the MNC’s parent in the period of concern should be counted. To

14

Part 1: The International Financial Environment

avoid double-counting, cash ﬂows of the MNC’s subsidiaries are considered in the valuation model only when they reﬂect transactions with the U.S. parent. Thus, any expected cash ﬂows received by foreign subsidiaries should not be counted in the valuation equation until they are expected to be remitted to the parent. The denominator of the valuation model for the MNC remains unchanged from the original valuation model for the purely domestic ﬁ rm. However, recognize that the weighted average cost of capital for the MNC is based on funding some projects that reﬂect business in different countries. Thus, any decision by the MNC’s parent that affects the cost of its capital supporting projects in a speciﬁc country can affect its weighted average cost of capital (and its required rate of return) and therefore can affect its value. In general, the valuation model shows that an MNC’s value can be affected by forces that inﬂuence the amount of its cash ﬂows in a particular currency (CFj), the exchange rate at which that currency is converted into dollars (Sj), or the MNC’s weighted average cost of capital (k).

Uncertainty Surrounding an MNC’s Cash Flows The MNC’s future cash ﬂows (and therefore its valuation) are subject to uncertainty because of its exposure to international economic conditions, political conditions, and exchange rate risk, as explained next. Exhibit 1.4 complements the discussion.

Exposure to International Economic Conditions. The amount of consumption in any country is inﬂuenced by the income earned by consumers in that country. If economic conditions weaken, the income of consumers becomes relatively low, consumer purchases of products decline, and an MNC’s sales in that country may be lower than expected. This results in a reduction in the MNC’s cash ﬂows, and therefore in its value.

Exposure to International Political Risk. Political risk (also called country risk) in any country can affect the level of an MNC’s sales. A foreign govern-

Exhibit 1.4

How an MNC’s Valuation Is Exposed to Uncertainty (Risk)

Uncertain foreign currency cash ﬂows due to uncertain foreign economic and political conditions

m

n

V冱

t1

冱 [E(CF

j,t )

Uncertainty surrounding future exchange rates

E (Sj,t )]

j1

(1 k )t

Uncertainty Surrounding an MNC’s Valuation: Exposure to Foreign Economies: If [CFj,t E (CFj,t )] Exposure to Political Risk: If [CFj,t E (CFj,t )]

V

V

Exposure to Exchange Rate Risk: If [Sj,t E (Sj,t )]

V

Chapter 1: Multinational Financial Management: An Overview

15

ment may increase taxes or impose barriers on the MNC’s subsidiary. Alternatively, consumers in a foreign country may boycott the MNC if there is friction between the government of their country and the MNC’s home country.

Exposure to Exchange Rate Risk. If the foreign currencies to be received by a U.S.-based MNC suddenly weaken against the dollar, the MNC will receive a lower amount of dollar cash ﬂows than was expected. This may reduce the value of the MNC.

Organization of the Text The organization of the chapters in this text is shown in Exhibit 1.5. Chapters 2 through 8 discuss international markets and conditions from a macroeconomic perspective, focusing on external forces that can affect the value of an MNC. Though ﬁ nancial managers may not have control over these forces, they do have some control over their degree of exposure to these forces. These macroeconomic chapters provide the background necessary to make ﬁ nancial decisions. Chapters 9 through 21 take a microeconomic perspective and focus on how the ﬁ nancial management of an MNC can affect its value. Financial decisions by MNCs are commonly classiﬁed as either investing decisions or ﬁ nancing decisions. In general, investing decisions by an MNC tend to affect the numerator of the valuation model because such decisions affect expected cash ﬂows. In addition, if investing decisions by the MNC’s parent alter the ﬁ rm’s weighted average cost of capital, they may also affect the denominator of the valuation model. Long-term ﬁ nancing decisions by an MNC’s parent tend to affect the denominator of the valuation model because they affect the MNC’s cost of capital.

Exhibit 1.5

Organization of Chapters

Background on International Financial Markets (Chapters 2–5)

Exchange Rate Behavior (Chapters 6–8)

Exchange Rate Risk Management (Chapters 9–12)

Long-Term Investment and Financing Decisions (Chapters 13–18)

Risk and Return of MNC

Short-Term Investment and Financing Decisions (Chapters 19–21)

Value and Stock Price of MNC

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Part 1: The International Financial Environment

SUMMARY ■ The main goal of an MNC is to maximize shareholder wealth. When managers are tempted to serve their own interests instead of those of shareholders, an agency problem exists. ■ International business is justiﬁed by three key theories. The theory of comparative advantage suggests that each country should use its comparative advantage to specialize in its production and rely on other countries to meet other needs. The imperfect markets theory suggests that because of imperfect markets, factors of production are immobile, which encourages countries to specialize based on the resources they have. The product cycle theory suggests that after ﬁ rms are established in their home countries, they commonly expand their product specialization in foreign countries.

POINT

■ The most common methods by which ﬁ rms conduct international business are international trade, licensing, franchising, joint ventures, acquisitions of foreign ﬁ rms, and formation of foreign subsidiaries. Methods such as licensing and franchising involve little capital investment but distribute some of the proﬁts to other parties. The acquisition of foreign ﬁ rms and formation of foreign subsidiaries require substantial capital investments but offer the potential for large returns. ■ The valuation model of an MNC shows that the MNC valuation is favorably affected when its foreign cash inﬂows increase, the currencies denominating those cash inﬂows increase, or the MNC’s required rate of return decreases.

COUNTER-POINT

Should an MNC Reduce Its Ethical Standards to Compete Internationally? Point Yes. When a U.S.-based MNC competes in some countries, it may encounter some business norms there that are not allowed in the United States. For example, when competing for a government contract, ﬁ rms might provide payoffs to the government ofﬁcials who will make the decision. Yet, in the United States, a ﬁ rm will sometimes take a client on an expensive golf outing or provide skybox tickets to events. This is no different than a payoff. If the payoffs are bigger in some foreign countries, the MNC can compete only by matching the payoffs provided by its competitors.

SELF

Counter-Point No. A U.S.-based MNC should maintain a standard code of ethics that applies to any country, even if it is at a disadvantage in a foreign country that allows activities that might be viewed as unethical. In this way, the MNC establishes more credibility worldwide. Who Is Correct? Use the Internet to learn more about this issue. Which argument do you support? Offer your own opinion on this issue.

TEST

Answers are provided in Appendix A at the back of the text. 1. What are typical reasons why MNCs expand internationally? 2. Explain why unfavorable economic or political conditions affect the MNC’s cash ﬂows, required rate of return, and valuation.

3. Identify the more obvious risks faced by MNCs that expand internationally.

Chapter 1: Multinational Financial Management: An Overview

QUESTIONS

AND

17

A P P L I CAT I O N S

1. Agency Problems of MNCs. a. Explain the agency problem of MNCs. b. Why might agency costs be larger for an MNC

than for a purely domestic ﬁ rm? 2. Comparative Advantage. a. Explain how the theory of comparative advan-

tage relates to the need for international business. b. Explain how the product cycle theory relates to

the growth of an MNC. 3. Imperfect Markets. a. Explain how the existence of imperfect markets

has led to the establishment of subsidiaries in foreign markets. b. If perfect markets existed, would wages, prices,

and interest rates among countries be more similar or less similar than under conditions of imperfect markets? Why? 4. International Opportunities. a. Do you think the acquisition of a foreign ﬁ rm or

licensing will result in greater growth for an MNC? Which alternative is likely to have more risk? b. Describe a scenario in which the size of a cor-

poration is not affected by access to international opportunities. c. Explain why MNCs such as Coca-Cola and

PepsiCo, Inc., still have numerous opportunities for international expansion. 5. International Opportunities Due to the Internet. a. What factors cause some ﬁ rms to become more

internationalized than others? b. Offer your opinion on why the Internet may re-

sult in more international business. 6. Impact of Exchange Rate Movements. Plak Co. of Chicago has several European subsidiaries that remit earnings to it each year. Explain how appreciation of the euro (the currency used in many European countries) would affect Plak’s valuation. 7. Beneﬁts and Risks of International Business. As an overall review of this chapter, identify possible reasons for growth in international business. Then, list the various disadvantages that may discourage international business. 8. Valuation of an MNC. Hudson Co., a U.S. ﬁ rm, has a subsidiary in Mexico, where political risk has recently increased. Hudson’s best guess of its future peso cash ﬂows to be received has not changed. However, its valuation has declined as a result of the increase in political risk. Explain.

9. Centralization and Agency Costs. Would the agency problem be more pronounced for Berkely Corp., which has its parent company make most major decisions for its foreign subsidiaries, or Oakland Corp., which uses a decentralized approach? 10. Global Competition. Explain why more standardized product speciﬁcations across countries can increase global competition. 11. Exposure to Exchange Rates. McCanna Corp., a U.S. ﬁ rm, has a French subsidiary that produces wine and exports to various European countries. All of the countries where it sells its wine use the euro as their currency, which is the same currency used in France. Is McCanna Corp. exposed to exchange rate risk? 12. Macro versus Micro Topics. Review the Table of Contents and indicate whether each of the chapters from Chapter 2 through Chapter 21 has a macro or micro perspective. 13. Methods Used to Conduct International Business. Duve, Inc., desires to penetrate a foreign market with either a licensing agreement with a foreign ﬁ rm or by acquiring a foreign ﬁ rm. Explain the differences in potential risk and return between a licensing agreement with a foreign ﬁ rm and the acquisition of a foreign ﬁ rm. 14. International Business Methods. Snyder Golf Co., a U.S. ﬁ rm that sells high-quality golf clubs in the United States, wants to expand internationally by selling the same golf clubs in Brazil. a. Describe the tradeoffs that are involved for each method (such as exporting, direct foreign investment, etc.) that Snyder could use to achieve its goal. b. Which method would you recommend for this ﬁ rm? Justify your recommendation. 15. Impact of Political Risk. Explain why political risk may discourage international business. 16. Impact of September 11. Following the terrorist attack on the United States, the valuations of many MNCs declined by more than 10 percent. Explain why the expected cash ﬂows of MNCs were reduced, even if they were not directly hit by the terrorist attacks. Advanced Questions 17. International Joint Venture. Anheuser-Busch, the producer of Budweiser and other beers, has recently expanded into Japan by engaging in a joint venture with Kirin Brewery, the largest brewery in Japan.

18

Part 1: The International Financial Environment

The joint venture enables Anheuser-Busch to have its beer distributed through Kirin’s distribution channels in Japan. In addition, it can utilize Kirin’s facilities to produce beer that will be sold locally. In return, Anheuser-Busch provides information about the American beer market to Kirin. a. Explain how the joint venture can enable An-

heuser-Busch to achieve its objective of maximizing shareholder wealth. b. Explain how the joint venture can limit the risk

of the international business. c. Many international joint ventures are intended to

circumvent barriers that normally prevent foreign competition. What barrier in Japan is AnheuserBusch circumventing as a result of the joint venture? What barrier in the United States is Kirin circumventing as a result of the joint venture? d. Explain how Anheuser-Busch could lose some of

its market share in countries outside Japan as a result of this particular joint venture. 18. Impact of Eastern European Growth. The managers of Loyola Corp. recently had a meeting to discuss new opportunities in Europe as a result of the recent integration among Eastern European countries. They decided not to penetrate new markets because of their present focus on expanding market share in the United States. Loyola’s ﬁ nancial managers have developed forecasts for earnings based on the 12 percent market share (deﬁ ned here as its percentage of total European sales) that Loyola currently has in Eastern Europe. Is 12 percent an appropriate estimate for next year’s Eastern European market share? If not, does it likely overestimate or underestimate the actual Eastern European market share next year? 19. Valuation of an MNC. Birm Co., based in Alabama, considers several international opportunities in Europe that could affect the value of its ﬁ rm. The valuation of its ﬁ rm is dependent on four factors: (1) expected cash ﬂows in dollars, (2) expected cash ﬂows in euros that are ultimately converted into dollars, (3) the rate at which it can convert euros to dollars, and (4) Birm’s weighted average cost of capital. For each opportunity, identify the factors that would be affected. a. Birm plans a licensing deal in which it will sell

technology to a ﬁ rm in Germany for $3 million; the payment is invoiced in dollars, and this project has the same risk level as its existing businesses. b. Birm plans to acquire a large ﬁ rm in Portugal

that is riskier than its existing businesses. c. Birm plans to discontinue its relationship with a

U.S. supplier so that it can import a small amount

of supplies (denominated in euros) at a lower cost from a Belgian supplier. d. Birm plans to export a small amount of materials to Ireland that are denominated in euros. 20. Assessing Motives for International Business. Fort Worth, Inc., specializes in manufacturing some basic parts for sports utility vehicles (SUVs) that are produced and sold in the United States. Its main advantage in the United States is that its production is efﬁcient and less costly than that of some other unionized manufacturers. It has a substantial market share in the United States. Its manufacturing process is labor intensive. It pays relatively low wages compared to U.S. competitors, but has guaranteed the local workers that their job positions will not be eliminated for the next 30 years. It hired a consultant to determine whether it should set up a subsidiary in Mexico, where the parts would be produced. The consultant suggested that Fort Worth should expand for the following reasons. Offer your opinion on whether the consultant’s reasons are logical. a. Theory of Competitive Advantage: There are not many SUVs sold in Mexico, so Fort Worth, Inc., would not have to face much competition there. b. Imperfect Markets Theory: Fort Worth cannot easily transfer workers to Mexico, but it can establish a subsidiary there in order to penetrate a new market. c. Product Cycle Theory: Fort Worth has been successful in the United States. It has limited growth opportunities because it already controls much of the U.S. market for the parts it produces. Thus, the natural next step is to conduct the same business in a foreign country. d. Exchange Rate Risk: The exchange rate of the peso has weakened recently, so this would allow Fort Worth to build a plant at a very low cost (by exchanging dollars for the cheap pesos to build the plant). e. Political Risk: The political conditions in Mexico have stabilized in the last few months, so Fort Worth should attempt to penetrate the Mexican market now. 21. Valuation of Wal-Mart’s International Business. In addition to all of its stores in the United States, Wal-Mart has 13 stores in Argentina, 302 stores in Brazil, 289 stores in Canada, 73 stores in China, 889 stores in Mexico, and 335 stores in the United Kingdom. Overall, it has 2,750 stores in foreign countries. Consider the value of Wal-Mart as being composed of two parts, a U.S. part (due to business in the United States) and a non-U.S. part (due to business in other countries). Explain how to determine the present value (in dollars) of the non-U.S.

Chapter 1: Multinational Financial Management: An Overview

part assuming that you had access to all the details of Wal-Mart businesses outside the United States. 22. Impact of International Business on Cash Flows and Risk. Nantucket Travel Agency specializes in tours for American tourists. Until recently, all of its business was in the United States. It just established a subsidiary in Athens, Greece, which provides tour services in the Greek islands for American tourists. It rented a shop near the port of Athens. It also hired residents of Athens who could speak English and provide tours of the Greek islands. The subsidiary’s main costs are rent and salaries for its employees and the lease of a few large boats in Athens that it uses for tours. American tourists pay for the entire tour in dollars at Nantucket’s main U.S. ofﬁce before they depart for Greece. a. Explain why Nantucket may be able to effectively

capitalize on international opportunities such as the Greek island tours. b. Nantucket is privately owned by owners who reside in the United States and work in the main ofﬁce. Explain possible agency problems associated with the creation of a subsidiary in Athens, Greece. How can Nantucket attempt to reduce these agency costs? c. Greece’s cost of labor and rent are relatively low. Explain why this information is relevant to Nantucket’s decision to establish a tour business in Greece. d. Explain how the cash ﬂow situation of the Greek tour business exposes Nantucket to exchange rate risk. Is Nantucket favorably or unfavorably affected when the euro (Greece’s currency) appreciates against the dollar? Explain. e. Nantucket plans to ﬁ nance its Greek tour business. Its subsidiary could obtain loans in euros from a bank in Greece to cover its rent, and its main ofﬁce could pay off the loans over time. Alternatively, its main ofﬁce could borrow dollars and would periodically convert dollars to euros to pay the expenses in Greece. Does either type of loan reduce the exposure of Nantucket to exchange rate risk? Explain. f. Explain how the Greek island tour business

could expose Nantucket to country risk.

BLADES,

INC.

19

23. Valuation of an MNC. Yahoo! has expanded its business by establishing portals in numerous countries, including Argentina, Australia, China, Germany, Ireland, Japan, and the United Kingdom. It has cash outﬂows associated with the creation and administration of each portal. It also generates cash inﬂows from selling advertising space on its website. Each portal results in cash ﬂows in a different currency. Thus, the valuation of Yahoo! is based on its expected future net cash ﬂows in Argentine pesos after converting them into U.S. dollars, its expected net cash ﬂows in Australian dollars after converting them into U.S. dollars, and so on. Explain how and why the valuation of Yahoo! would change if most investors suddenly expected that the dollar would weaken against most currencies over time. 24. Uncertainty Surrounding an MNC’s Valuation. Carlisle Co. is a U.S. ﬁ rm that is about to purchase a large company in Switzerland at a purchase price of $20 million. This company produces furniture and sells it locally (in Switzerland), and it is expected to earn large proﬁts every year. The company will become a subsidiary of Carlisle and will periodically remit its excess cash ﬂows due to its proﬁts to Carlisle Co. Assume that Carlisle Co. has no other international business. Carlisle has $10 million that it will use to pay for part of the Swiss company and will ﬁ nance the rest of its purchase with borrowed dollars. Carlisle Co. can obtain supplies from either a U.S. supplier or a Swiss supplier (in which case the payment would be made in Swiss francs). Both suppliers are very reputable and there would be no exposure to country risk when using either supplier. Is the valuation of the total cash ﬂows of Carlisle Co. more uncertain if it obtains its supplies from a U.S. ﬁ rm or a Swiss ﬁ rm? Explain brieﬂy. Discussion in the Boardroom This exercise can be found in Appendix E at the back of this textbook. Running Your Own MNC This exercise can be found on the Xtra! website at http://maduraxtra.swlearning.com.

CASE

Decision to Expand Internationally Blades, Inc., is a U.S.-based company that has been incorporated in the United States for three years. Blades is a relatively small company, with total assets of only $200 million. The company produces a single type of

product, roller blades. Due to the booming roller blade market in the United States at the time of the company’s establishment, Blades has been quite successful. For example, in its ﬁ rst year of operation, it reported a

20

Part 1: The International Financial Environment

net income of $3.5 million. Recently, however, the demand for Blades’ “Speedos,” the company’s primary product in the United States, has been slowly tapering off, and Blades has not been performing well. Last year, it reported a return on assets of only 7 percent. In response to the company’s annual report for its most recent year of operations, Blades’ shareholders have been pressuring the company to improve its performance; its stock price has fallen from a high of $20 per share three years ago to $12 last year. Blades produces high-quality roller blades and employs a unique production process, but the prices it charges are among the top 5 percent in the industry. In light of these circumstances, Ben Holt, the company’s chief ﬁ nancial ofﬁcer (CFO), is contemplating his alternatives for Blades’ future. There are no other cost-cutting measures that Blades can implement in the United States without affecting the quality of its product. Also, production of alternative products would require major modiﬁcations to the existing plant setup. Furthermore, and because of these limitations, expansion within the United States at this time seems pointless. Ben Holt is considering the following: If Blades cannot penetrate the U.S. market further or reduce costs here, why not import some parts from overseas and/or expand the company’s sales to foreign countries? Similar strategies have proved successful for numerous companies that expanded into Asia in recent years to increase their proﬁt margins. The CFO’s initial focus is on Thailand. Thailand has recently experienced weak economic conditions, and Blades could purchase components there at a low cost. Ben Holt is aware that many of Blades’ competitors have begun importing production components from Thailand. Not only would Blades be able to reduce costs by importing rubber and/or plastic from Thailand due to the low costs of these inputs, but it might also be able to augment weak U.S. sales by exporting to Thai-

SMALL

BUSINESS

land, an economy still in its infancy and just beginning to appreciate leisure products such as roller blades. While several of Blades’ competitors import components from Thailand, few are exporting to the country. Long-term decisions would also eventually have to be made; maybe Blades, Inc., could establish a subsidiary in Thailand and gradually shift its focus away from the United States if its U.S. sales do not rebound. Establishing a subsidiary in Thailand would also make sense for Blades due to its superior production process. Ben Holt is reasonably sure that Thai ﬁ rms could not duplicate the high-quality production process employed by Blades. Furthermore, if the company’s initial approach of exporting works well, establishing a subsidiary in Thailand would preserve Blades’ sales before Thai competitors are able to penetrate the Thai market. As a ﬁ nancial analyst for Blades, Inc., you are assigned to analyze international opportunities and risk resulting from international business. Your initial assessment should focus on the barriers and opportunities that international trade may offer. Ben Holt has never been involved in international business in any form and is unfamiliar with any constraints that may inhibit his plan to export to and import from a foreign country. Mr. Holt has presented you with a list of initial questions you should answer. 1. What are the advantages Blades could gain from importing from and/or exporting to a foreign country such as Thailand? 2. What are some of the disadvantages Blades could face as a result of foreign trade in the short run? In the long run? 3. Which theories of international business described in this chapter apply to Blades, Inc., in the short run? In the long run? 4. What long-range plans other than establishment of a subsidiary in Thailand are an option for Blades and may be more suitable for the company?

DILEMMA

Developing a Multinational Sporting Goods Corporation In every chapter of this text, some of the key concepts are illustrated with an application to a small sporting goods ﬁ rm that conducts international business. These “Small Business Dilemma” features allow students to recognize the dilemmas and possible decisions that ﬁ rms (such as this sporting goods ﬁ rm) may face in a global environment. For this chapter, the application is on the development of the sporting goods ﬁ rm that would conduct international business.

Last month, Jim Logan completed his undergraduate degree in ﬁ nance and decided to pursue his dream of managing his own sporting goods business. Jim had worked in a sporting goods shop while going to college, and he had noticed that many customers wanted to purchase a low-priced football. However, the sporting goods store where he worked, like many others, sold only top-of-the-line footballs. From his experience, Jim was aware that top-of-the-line footballs

Chapter 1: Multinational Financial Management: An Overview

had a high markup and that a low-cost football could possibly penetrate the U.S. market. He also knew how to produce footballs. His goal was to create a ﬁ rm that would produce low-priced footballs and sell them on a wholesale basis to various sporting goods stores in the United States. Unfortunately, many sporting goods stores began to sell low-priced footballs just before Jim was about to start his business. The ﬁ rm that began to produce the low-cost footballs already provided many other products to sporting goods stores in the United States and therefore had already established a business relationship with these stores. Jim did not believe that he could compete with this ﬁ rm in the U.S. market. Rather than pursue a different business, Jim decided to implement his idea on a global basis. While football (as it is played in the United States) has not been a traditional sport in foreign countries, it has become more popular in some foreign countries in recent years. Furthermore, the expansion of cable networks in foreign countries would allow for much more exposure to U.S. football games in those countries in the future. To the extent that this would increase the popularity of football (U.S. style) as a hobby in the foreign countries, it would result in a demand for footballs in foreign countries. Jim asked many of his foreign friends from college days if they recalled seeing footballs sold in their home countries. Most of them said they rarely noticed footballs being sold in sporting goods stores but that they expected the demand for footballs to increase in their home countries. Consequently, Jim decided to start a business of producing low-priced footballs and exporting them to sporting goods distributors in for-

I N T E R N E T/ E XC E L The website address of the Bureau of Economic Analysis is http://www.bea.gov. 1. Use this website to assess recent trends in direct foreign investment (DFI) abroad by U.S. ﬁ rms. Compare the DFI in the United Kingdom with the DFI in France. Offer a possible reason for the large difference.

21

eign countries. Those distributors would then sell the footballs at the retail level. Jim planned to expand his product line over time once he identiﬁed other sports products that he might sell to foreign sporting goods stores. He decided to call his business “Sports Exports Company.” To avoid any rent and labor expenses, Jim planned to produce the footballs in his garage and to perform the work himself. Thus, his main business expenses were the cost of the materials used to produce footballs and expenses associated with ﬁ nding distributors in foreign countries who would attempt to sell the footballs to sporting goods stores. 1. Is Sports Exports Company a multinational corporation? 2. Why are the agency costs lower for Sports Exports Company than for most MNCs? 3. Does Sports Exports Company have any comparative advantage over potential competitors in foreign countries that could produce and sell footballs there? 4. How would Jim Logan decide which foreign markets he would attempt to enter? Should he initially focus on one or many foreign markets? 5. The Sports Exports Company has no immediate plans to conduct direct foreign investment. However, it might consider other less costly methods of establishing its business in foreign markets. What methods might the Sports Exports Company use to increase its presence in foreign markets by working with one or more foreign companies?

EXERCISES 2. Based on the recent trends in DFI, are U.S.-based MNCs pursuing opportunities in Asia? In Eastern Europe? In Latin America?

2: International Flow of Funds International business is facilitated by markets that allow for the ﬂow of funds between countries. The transactions arising from international business cause money ﬂows from one country to another. The balance of payments is a measure of international money ﬂows and is discussed in this chapter. Financial managers of MNCs monitor the balance of payments so that they can determine how the ﬂow of international transactions is changing over time. The balance of payments can indicate the volume of transactions between speciﬁc countries and may

even signal potential shifts in speciﬁc exchange rates. The specific objectives of this chapter are to: ■ explain the key components of the balance of

payments, ■ explain how international trade flows are influenced by

economic factors and other factors, and ■ explain how international capital flows are influenced

by country characteristics.

Balance of Payments The balance of payments is a summary of transactions between domestic and foreign residents for a speciﬁc country over a speciﬁed period of time. It represents an accounting of a country’s international transactions for a period, usually a quarter or a year. It accounts for transactions by businesses, individuals, and the government. A balance-of-payments statement can be broken down into various components. Those that receive the most attention are the current account and the capital account. The current account represents a summary of the ﬂow of funds between one speciﬁed country and all other countries due to purchases of goods or services, or the provision of income on ﬁ nancial assets. The capital account represents a summary of the ﬂow of funds resulting from the sale of assets between one speciﬁed country and all other countries over a speciﬁed period of time. Thus, it compares the new foreign investments made by a country with the foreign investments within a country over a particular time period. Transactions that reﬂect inﬂows of funds generate positive numbers (credits) for the country’s balance, while transactions that reﬂect outﬂows of funds generate negative numbers (debits) for the country’s balance.

Current Account The main components of the current account are payments for (1) merchandise (goods) and services, (2) factor income, and (3) transfers.

Payments for Merchandise and Services. Merchandise exGetty Images

ports and imports represent tangible products, such as computers and clothing, that are transported between countries. Service exports and imports represent tourism and other services, such as legal, insurance, and consulting services, provided for customers based in other countries. Service exports by the United States result in an

22

Chapter 2: International Flow of Funds

23

inﬂow of funds to the United States, while service imports by the United States result in an outﬂow of funds. The difference between total exports and imports is referred to as the balance of trade. A deﬁcit in the balance of trade means that the value of merchandise and services exported by the United States is less than the value of merchandise and services imported by the United States. Before 1993, the balance of trade focused on only merchandise exports and imports. In 1993, it was redeﬁ ned to include service exports and imports as well. The value of U.S. service exports usually exceeds the value of U.S. service imports. However, the value of U.S. merchandise exports is typically much smaller than the value of U.S. merchandise imports. Overall, the United States normally has a negative balance of trade.

Factor Income Payments. A second component of the current account is factor income, which represents income (interest and dividend payments) received by investors on foreign investments in ﬁ nancial assets (securities). Thus, factor income received by U.S. investors reﬂects an inﬂow of funds into the United States. Factor income paid by the United States reﬂects an outﬂow of funds from the United States.

Transfer Payments. A third component of the current account is transfer payments, which represent aid, grants, and gifts from one country to another.

Examples of Payment Entries. Exhibit 2.1 shows several examples of transactions that would be reﬂected in the current account. Notice in the exhibit that every transaction that generates a U.S. cash inﬂow (exports and income receipts by the United States) represents a credit to the current account, while every transaction that generates a U.S. cash outﬂow (imports and income payments by the United States) represents a debit to the current account. Therefore, a large current account deﬁcit indicates that the United States is sending more cash abroad to buy goods and services or to pay income than it is receiving for those same reasons.

Actual Current Account Balance. The U.S. current account balance in the year 2006 is summarized in Exhibit 2.2. Notice that the exports of merchandise were valued at $1,019 billion, while imports of merchandise by the United States were valued at $1,836 billion. Total U.S. exports of merchandise and services and income receipts amounted to $2,056 billion, while total U.S. imports amounted to $2,793 billion. The bottom of the exhibit shows that net transfers (which include grants and gifts provided to other countries) were $54 billion. The negative number for net transfers represents a cash outﬂow from the United States. Exhibit 2.2 shows that the current account balance (line 10) can be derived as the difference between total U.S. exports and income receipts (line 4) and the total U.S. imports and income payments (line 8), with an adjustment for net transfer payments (line 9). This is logical, since the total U.S. exports and income receipts represent U.S. cash inﬂows while the total U.S. imports and income payments and the net transfers represent U.S. cash outﬂows. The negative current account balance means that the United States spent more on trade, income, and transfer payments than it received.

Capital and Financial Accounts The capital account category has been changed to separate it from the ﬁ nancial account, which is described next. The capital account includes the value of ﬁ nancial assets transferred across country borders by people who move to a different country. It also includes the value of nonproduced nonﬁ nancial assets that are transferred across country borders, such as patents and trademarks. The sale of patent rights by a U.S. ﬁ rm to a Canadian ﬁ rm reﬂects a credit to the U.S. balance-of-payments ac-

24

Part 1: The International Financial Environment Exhibit 2.1

Examples of Current Account Transactions

International Trade Transaction

U.S. Cash Flow Position

Entry on U.S. Balanceof-Payments Account

J.C. Penney purchases stereos produced in Indonesia that it will sell in its U.S. retail stores.

U.S. cash outﬂow

Debit

Individuals in the United States purchase CDs over the Internet from a ﬁrm based in China.

U.S. cash outﬂow

Debit

The Mexican government pays a U.S. consulting ﬁrm for consulting services provided by the ﬁrm.

U.S. cash inﬂow

Credit

IBM headquarters in the United States purchases computer chips from Singapore that it uses in assembling computers.

U.S. cash outﬂow

Debit

A university bookstore in Ireland purchases textbooks produced by a U.S. publishing company.

U.S. cash inﬂow

Credit

International Income Transaction

U.S. Cash Flow Position

Entry on U.S. Balanceof-Payments Account

A U.S. investor receives a dividend payment from a French ﬁrm in which she purchased stock.

U.S. cash inﬂow

Credit

The U.S. Treasury sends an interest payment to a German insurance company that purchased U.S. Treasury bonds one year ago.

U.S. cash outﬂow

Debit

A Mexican company that borrowed dollars from a bank based in the United States sends an interest payment to that bank.

U.S. cash inﬂow

Credit

International Transfer Transaction

U.S. Cash Flow Position

Entry on U.S. Balanceof-Payments Account

The United States provides aid to Costa Rica in response to a ﬂood in Costa Rica.

U.S. cash outﬂow

Debit

Switzerland provides a grant to U.S. scientists to work on cancer research.

U.S. cash inﬂow

Credit

count, while a U.S. purchase of patent rights from a Canadian ﬁ rm reﬂects a debit to the U.S. balance-of-payments account. The capital account items are relatively minor compared to the ﬁ nancial account items. The key components of the ﬁ nancial account are payments for (1) direct foreign investment, (2) portfolio investment, and (3) other capital investment.

Direct Foreign Investment. Direct foreign investment represents the investment in ﬁ xed assets in foreign countries that can be used to conduct business operations. Examples of direct foreign investment include a ﬁ rm’s acquisition of a foreign company, its construction of a new manufacturing plant, or its expansion of an

Chapter 2: International Flow of Funds Exhibit 2.2

Summary of U.S. Current Account in the Year 2006 (in billions of $)

U.S. exports of merchandise

$1,019

(2)

U.S. exports of services

411

(3)

U.S. income receipts

626

(4)

Total U.S. exports and income receipts

$2,056

U.S. imports of merchandise

$1,836

U.S. imports of services

341

(1)

(5) (6) (7)

U.S. income payments

616

(8)

Total U.S. imports and income payments

$2,793

Net transfers by the U.S.

$54

Current account balance (4) (8) (9)

$791

(9) (10)

25

existing plant in a foreign country. In 2006, the United States increased its direct foreign investment abroad by $248 billion, while non-U.S. countries increased their direct foreign investment in the United States by $185 billion.

Portfolio Investment. Portfolio investment represents transactions involving long-term ﬁ nancial assets (such as stocks and bonds) between countries that do not affect the transfer of control. Thus, a purchase of Heineken (Netherlands) stock by a U.S. investor is classiﬁed as portfolio investment because it represents a purchase of foreign ﬁ nancial assets without changing control of the company. If a U.S. ﬁ rm purchased all of Heineken’s stock in an acquisition, this transaction would result in a transfer of control and therefore would be classiﬁed as direct foreign investment instead of portfolio investment. In 2006, the U.S. net purchases of foreign stocks were $129 billion, while its net purchases of foreign bonds were $149 billion. Non-U.S. net purchases of U.S. stocks were $114 billion in 2006, while non-U.S. net purchases of U.S. bonds were $507 billion.

Other Capital Investment. A third component of the ﬁ nancial account consists of other capital investment, which represents transactions involving shortterm ﬁ nancial assets (such as money market securities) between countries. In general, direct foreign investment measures the expansion of ﬁ rms’ foreign operations, whereas portfolio investment and other capital investment measure the net ﬂow of funds due to ﬁ nancial asset transactions between individual or institutional investors.

Errors and Omissions and Reserves. If a country has a negative current account balance, it should have a positive capital and ﬁ nancial account balance. This implies that while it sends more money out of the country than it receives from other countries for trade and factor income, it receives more money from other countries than it spends for capital and ﬁ nancial account components, such as investments. In fact, the negative balance on the current account should be offset by a positive balance on the capital and ﬁ nancial account. However, there is not normally a perfect offsetting effect because measurement errors can occur when attempting to measure the value of funds transferred into or out of a country. For this reason, the balance-of-payments account includes a category of errors and omissions.

International Trade Flows Canada, France, Germany, and other European countries rely more heavily on trade than the United States does. Canada’s trade volume of exports and imports per year

26

Part 1: The International Financial Environment

is valued at more than 50 percent of its annual gross domestic product (GDP). The trade volume of European countries is typically between 30 and 40 percent of their respective GDPs. The trade volume of the United States and Japan is typically between 10 and 20 percent of their respective GDPs. Nevertheless, for all countries, the volume of trade has grown over time. As of 2006, exports represented about 18 percent of U.S. GDP.

H T T P : // http://www.whitehouse.gov/ fsbr/international.htm Update of the current account balance and international trade balance.

H T T P : // http://www.ita.doc.gov/td/ industry/otea An outlook of international trade conditions for each of several industries.

Distribution of U.S. Exports and Imports The dollar value of U.S. exports to various countries during 2006 is shown in Exhibit 2.3. The amounts of U.S. exports are rounded to the nearest billion. For example, exports to Canada were valued at $230 billion. The proportion of total U.S. exports to various countries is shown at the top of Exhibit 2.4. About 23 percent of all U.S. exports are to Canada, while 13 percent of U.S. exports are to Mexico. The proportion of total U.S. imports from various countries is shown at the bottom of Exhibit 2.4. Canada, China, Mexico, and Japan are the key exporters to the United States: Together, they are responsible for more than half of the value of all U.S. imports.

U.S. Balance-of-Trade Trend

H T T P : // http://www.ita.doc.gov Access to a variety of traderelated country and sector statistics.

H T T P : // http://www.census.gov/ foreign-trade/balance Click on a speciﬁc country. The balance of trade with the country you specify is shown for several recent years.

H T T P : // http://www.census.gov/ foreign-trade/www/press .html Trend of the U.S. balance of trade in aggregate. Click on U.S. International Trade in Goods and Services. There are several links here to additional details about the U.S. balance of trade.

Recent trends for U.S. exports, U.S. imports, and the U.S. balance of trade are shown in Exhibit 2.5. Notice that the value of U.S. exports and U.S. imports has grown substantially over time. Since 1976, the value of U.S. imports has exceeded the value of U.S. exports, causing a balance-of-trade deﬁcit. Much of the trade deﬁcit is due to a trade imbalance with just two countries, China and Japan. In 2006, U.S. exports to China were about $55 billion, but imports from China were about $255 billion, which resulted in a balance-of-trade deﬁcit of $200 billion with China. Any country’s balance of trade can change substantially over time. Shortly after World War II, the United States experienced a large balance-of-trade surplus because Europe relied on U.S. exports as it was rebuilt. During the last decade, the United States has experienced balance-of-trade deﬁcits because of strong U.S. demand for imported products that are produced at a lower cost than similar products can be produced in the United States.

Should the United States Be Concerned about a Huge Balance-of-Trade Deficit? If ﬁ rms, individuals, or government agencies from the United States purchased all their products from U.S. ﬁ rms, their payments would have resulted in revenue to U.S. ﬁ rms, which would also contribute to earnings for the shareholders. In addition, if the purchases were directed at U.S. ﬁ rms, these ﬁ rms would need to produce more products and could hire more employees. Thus, the U.S. unemployment rate might be lower if U.S. purchases were focused on products produced within the United States. In reality, the United States sends more than $200 billion in payments for products per year to other countries than what it receives when selling products to other countries. Thus, international trade has created jobs in foreign countries, which replace some jobs in the United States. However, there are some beneﬁts of international trade for the United States. First, international trade has created some jobs in the United States, especially in industries where U.S. ﬁ rms have a technology advantage. International trade has caused a shift of production to countries that can produce products more efﬁciently. In addition, it ensures more competition among the ﬁ rms that produce products, which forces the ﬁ rms to keep their prices low.

Belgium 21

Costa Rica 4 Colombia 6 Ecuador 3

Finland 3

Bahamas 2 Dominican Republic 5 Jamaica 2

Venezuela 9

Portugal 2

Czech Republic 1 Poland 2 Switzerland Germany 14 41 France Hungary 24 Austria 1 3 Spain Italy 8 13 Albania Greece 2 3

Russia 5

South Korea 32 Pakistan 2 Turkey 6

China 55 Hong Kong 18

India 10

Peru 3

Brazil 19

Taiwan 23 Philippines 8

Thailand 8 Singapore 25

Japan 59

Malaysia 13

Indonesia 3

Australia 17

Chile 7 Argentina 5

Source: U.S. Census Bureau, 2007.

New Zealand 3

Distribution of U.S. Exports across Countries (in billions of $)

Canada 230

Mexico 134

Exhibit 2.3

Sweden 4 Norway 2 Denmark 2 Netherlands 31 United Kingdom 45 Ireland 9

28

Part 1: The International Financial Environment Exhibit 2.4

2006 Distribution of U.S. Exports and Imports

Distribution of Exports

United Kingdom France 2% 4%

Mexico 13% China 5% Japan 6% Germany 4%

Other 43%

Canada 23%

Distribution of Imports Mexico 10%

China 16%

United Kingdom 3% France 2% Japan 8% Germany 5%

Other 39% Canada 17%

Source: Federal Reserve, 2007.

International Trade Issues H T T P : // http://www.census.gov/ foreign-trade/www/press .html Click on U.S. International Trade in Goods and Services. There are several links here to additional details about the U.S. balance of trade.

Given the importance of international trade and the potential impact that a government can have on trade, governments continually seek trade policies that are fair to all countries. Much progress has been made as a result of several events that have either reduced or eliminated trade restrictions.

Events That Increased International Trade The following events reduced trade restrictions and increased international trade.

Removal of the Berlin Wall. In 1989, the Berlin Wall separating East Germany from West Germany was torn down. This was symbolic of new relations between East Germany and West Germany and was followed by the reuniﬁcation of the two countries. It encouraged free enterprise in all Eastern European countries and the privatization of businesses that were owned by the government. It also led to major reductions in trade barriers in Eastern Europe. Many MNCs began to export

Billion of U.S. $

Exhibit 2.5

U.S. Balance of Trade over Time

2,050 2,000 1,950 1,900 1,850 1,800 1,750 1,700 1,650 1,600 1,550 1,500 1,450 1,400 1,350 1,300 1,250 1,200 1,150 1,100 1,050 1,000 950 900 850 800 750 700 650 600 550 500 450 400 350 300 250 200 150 100 50 0 50 1991 100 150 200 250 300 350 400 450 500 550 600 650 700 750 800

U.S. Imports

U.S. Exports

1992

1993

1994

1995

1996

1997

1998

1999

U.S. Balance-of-Trade Deﬁcit

Year Source: U.S. Census Bureau, 2007.

2000

2001

2002

2003

2004

2005

2006

30

Part 1: The International Financial Environment

products there, while others capitalized on the cheap labor costs by importing supplies from there.

Single European Act. In the late 1980s, industrialized countries in Europe agreed to make regulations more uniform and to remove many taxes on goods traded between these countries. This agreement, supported by the Single European Act of 1987, was followed by a series of negotiations among the countries to achieve uniform policies by 1992. The act allows ﬁ rms in a given European country greater access to supplies from ﬁ rms in other European countries. Many ﬁ rms, including European subsidiaries of U.S.-based MNCs, have capitalized on the agreement by attempting to penetrate markets in border countries. By producing more of the same product and distributing it across European countries, ﬁ rms are now better able to achieve economies of scale. Best Foods (now part of Unilever) was one of many MNCs that increased efﬁciency by streamlining manufacturing operations as a result of the reduction in barriers. NAFTA. As a result of the North American Free Trade Agreement (NAFTA) of 1993, trade barriers between the United States and Mexico were eliminated. Some U.S. ﬁ rms attempted to capitalize on this by exporting goods that had previously been restricted by barriers to Mexico. Other ﬁ rms established subsidiaries in Mexico to produce their goods at a lower cost than was possible in the United States and then sell the goods in the United States. The removal of trade barriers essentially allowed U.S. ﬁ rms to penetrate product and labor markets that previously had not been accessible. The removal of trade barriers between the United States and Mexico allows Mexican ﬁ rms to export some products to the United States that were previously restricted. Thus, U.S. ﬁ rms that produce these goods are now subject to competition from Mexican exporters. Given the low cost of labor in Mexico, some U.S. ﬁ rms have lost some of their market share. The effects are most pronounced in the laborintensive industries. Within a month after the NAFTA accord, the momentum for free trade continued with a GATT (General Agreement on Tariffs and Trade) accord. This accord was the conclusion of trade negotiations from the so-called Uruguay Round that had begun 7 years earlier. It called for the reduction or elimination of trade restrictions on speciﬁed imported goods over a 10-year period across 117 countries. The accord has generated more international business for ﬁ rms that had previously been unable to penetrate foreign markets because of trade restrictions.

H T T P : // http://www.ecb.int Update of information on the euro.

Inception of the Euro. In 1999, several European countries adopted the euro as their currency for business transactions between these countries. The euro was phased in as a currency for other transactions during 2001 and completely replaced the currencies of the participating countries on January 1, 2002. Consequently, only the euro is used for transactions in these countries, so ﬁ rms (including European subsidiaries of U.S.-based MNCs) no longer face the costs and risks associated with converting one currency to another. The single currency system in most of Europe encouraged more trade among European countries. Expansion of the European Union. In 2004, Cyprus, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia, and Slovenia were admitted to the EU, followed by Bulgaria and Romania in 2007. Slovenia adopted the euro as its currency in 2007. The other new members continued to use their own currencies, but may be able to adopt the euro as their currency in the fu-

Chapter 2: International Flow of Funds

31

ture if they meet speciﬁed guidelines regarding budget deﬁcits and other ﬁ nancial conditions. Nevertheless, their admission into the EU is relevant because restrictions on their trade with Western Europe are reduced. Since wages in these countries are substantially lower than in Western European countries, many MNCs have established manufacturing plants there to produce products and export them to Western Europe.

Other Trade Agreements. In June 2003, the United States and Chile signed a free trade agreement to remove tariffs on products traded between the two countries. In 2006, the Central American Trade Agreement (CAFTA) was implemented, allowing for lower tariffs and regulations between the United States, the Dominican Republic, and four Central American countries. In addition, there is an initiative for Caribbean nations to create a single market in which there is the free ﬂow of trade, capital, and workers across countries. The United States has also established trade agreements with many other countries.

Trade Friction International trade policies partially determine which ﬁ rms get most of the market share within an industry. These policies affect each country’s unemployment level, income level, and economic growth. Even though trade treaties have reduced tariffs and quotas over time, most countries still impose some type of trade restrictions on particular products in order to protect their local ﬁ rms. An easy way to start an argument among students (or professors) is to ask what they think the policy on international trade should be. People whose job prospects are highly inﬂuenced by international trade tend to have very strong opinions about international trade policy. On the surface, most people agree that free trade can be beneﬁcial because it encourages more intense competition among ﬁ rms, which enables consumers to obtain products where the quality is highest and the prices are low. Free trade should cause a shift in production to those countries where it can be done most efﬁciently. Each country’s government wants to increase its exports because more exports result in a higher level of production and income and may create jobs. However, a job created in one country may be lost in another, which causes countries to battle for a greater share of the world’s exports. People disagree on the type of strategies a government should be allowed to use to increase its respective country’s share of the global market. They may agree that a tariff or quota on imported goods prevents free trade and gives local ﬁ rms an unfair advantage in their own market. Yet, they disagree on whether governments should be allowed to use other more subtle trade restrictions against foreign ﬁ rms or provide incentives that give local ﬁ rms an unfair advantage in the battle for global market share. Consider the following situations that commonly occur: 1. The firms based in one country are not subject to environmental restrictions and, therefore, can produce at a lower cost than firms in other countries. 2. The firms based in one country are not subject to child labor laws and are able to produce products at a lower cost than firms in other countries by relying mostly on children to produce the products. 3. The firms based in one country are allowed by their government to offer bribes to large customers when pursuing business deals in a particular industry. They have a competitive advantage over firms in other countries that are not allowed to offer bribes. 4. The firms in one country receive subsidies from the government, as long as they export the products. The exporting of products that were produced with the help

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of government subsidies is commonly referred to as dumping. These firms may be able to sell their products at a lower price than any of their competitors in other countries. 5. The firms in one country receive tax breaks if they are in specific industries. This practice is not necessarily a subsidy, but it still is a form of government financial support.

H T T P : // http://www.worldbank .org/data/wdi2000/pdfs/ tab6_5.pdf Trade statistics within a speciﬁc trading block.

In all of these situations, ﬁ rms in one country may have an advantage over ﬁ rms in other countries. Every government uses some strategies that may give its local ﬁ rms an advantage in the ﬁght for global market share. Thus, the playing ﬁeld in the battle for global market share is probably not even across all countries. Yet, there is no formula that will ensure a fair battle for market share. Regardless of the progression of international trade treaties, governments will always be able to ﬁ nd strategies that can give their local ﬁ rms an edge in exporting. Suppose, as an extreme example, that a new international treaty outlawed all of the strategies described above. One country’s government could still try to give its local ﬁ rms a trade advantage by attempting to maintain a relatively weak currency. This strategy can increase foreign demand for products produced locally because products denominated in a weak currency can be purchased at a low price.

Using the Exchange Rate as a Policy. At any given point in time, a group of exporters may claim that they are being mistreated and lobby their government to adjust the currency so that their exports will not be so expensive for foreign purchasers. In 2004, European exporters claimed that they were at a disadvantage because the euro was too strong. Meanwhile, U.S. exporters still claimed that they could not compete with China because the Chinese currency (yuan) was maintained at an artiﬁcially weak level. In July 2005, China revalued the yuan by 2.1 percent against the dollar in response to criticism. It also implemented a new system in which the yuan could ﬂoat within narrow boundaries based on a set of major currencies. In May 2007, China widened the band so that the yuan could deviate by as much as .5 percent within a day. This had a very limited effect on the relative pricing of Chinese versus U.S. products and, therefore, on the balance of trade between the two countries. Outsourcing. One of the most recent issues related to trade is the outsourcing of services. For example, technology support of computer systems used in the United States may be outsourced to India, Bulgaria, China, or other countries where labor costs are low. Outsourcing affects the balance of trade because it means that a service is purchased in another country. This form of international trade allows MNCs to conduct operations at a lower cost. However, it shifts jobs to other countries and is criticized by the people who lose their jobs due to the outsourcing. Many people have opinions about outsourcing, which are often inconsistent with their own behavior. As a U.S. citizen, Rick says he is embarrassed by U.S. firms that outsource their labor services to other countries as a means of increasing their value because this practice eliminates jobs in the United States. Rick is president of Atlantic Co. and says the company will never outsource its services. Atlantic Co. imports most of its materials from a foreign company. It also owns a factory in Mexico, and the materials produced in Mexico are exported to the United States. Rick recognizes that outsourcing may replace jobs in the United States. Yet, he does not realize that importing materials or operating a factory in Mexico may also have replaced jobs in the United States. If questioned about his use of foreign labor markets for materials or production, he would likely explain that the high manufacturing wages in the United States force him

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Chapter 2: International Flow of Funds

33

to rely on lower-cost labor in foreign countries. Yet, the same argument could be used by other U.S. firms that outsource services. Rick owns a Toyota, a Nokia cell phone, a Toshiba computer, and Adidas clothing. He argues that these non-U.S. products are a better value for the money than U.S. products. Nicole, a friend of Rick, suggests that his consumption choices are inconsistent with his “create U.S. jobs” philosophy. She explains that she only purchases U.S. products. She owns a Ford (produced in Mexico), a Motorola telephone (components produced in Asia), a Compaq computer (produced in China), and Nike clothing (produced in Indonesia). ■ Should Managers Outsource to Satisfy Shareholders? Managers of a U.S.-based MNC may argue that they produce their products in the United States to create jobs for U.S. workers. However, when the same products can be easily duplicated in foreign markets for one-fifth of the cost, shareholders may pressure the managers to establish a foreign subsidiary or to engage in outsourcing. Shareholders may suggest that the managers are not maximizing the MNC’s value as a result of their commitment to creating U.S. jobs. The MNC’s board of directors governs the major managerial decisions and could pressure the managers to have some of the production moved outside the United States. The board should consider the potential savings that could occur as a result of having products produced outside the United States. However, it must also consider the possible adverse effects due to bad publicity or to bad morale that could occur among the U.S. workers. If the production cost could be substantially reduced outside the United States without a loss in quality, a possible compromise is to allow foreign production to accommodate any growth in its business. In this way, the strategy would not adversely affect the existing employees involved in production. ■

GO OV E ER RN NA AN NC CE E

Using Trade and Foreign Ownership Policies for Security Reasons. Some U.S. politicians have argued that international trade and foreign ownership should be restricted when U.S. security is threatened. While the general opinion has much support, there is disagreement regarding the speciﬁc business transactions in which U.S. businesses deserve protection from foreign competition. Consider the following questions: 1. Should the United States purchase military planes only from a U.S. producer of planes, even when Brazil could produce the same planes for half the price? The tradeoff involves a larger budget deficit for increased security. Is the United States truly safer with planes produced in the United States? Are technology secrets safer when the production is in the United States by a U.S. firm? 2. If you think military planes should be produced only by a U.S. firm, should there be any restrictions on foreign ownership of the firm? Foreign investors own a proportion of most large publicly traded companies in the United States. 3. Should foreign ownership restrictions be imposed only on investors based in some countries? Or is there a concern that owners based in any foreign country should be banned from doing business transactions when U.S. security is threatened? What is the threat? Is it that the owners could sell technology secrets to enemies? If so, isn’t such a threat also possible for U.S. owners? If some foreign owners are acceptable, what countries would be acceptable? 4. What products should be viewed as a threat to U.S. security? For example, even if military planes were required to be produced by U.S. firms, what about all the components that are used within the production of the planes? Some of the components used in U.S. military plane production are produced in China and imported by the plane manufacturers.

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To realize the degree of disagreement about these issues, try to get a consensus answer on any of these questions from your fellow students in a single classroom. If students without hidden agendas cannot agree on the answer, consider the level of disagreement among owners or employees of U.S. and foreign ﬁ rms that have much to gain (or lose) from the international trade and investment policy that is implemented. It is difﬁcult to distinguish between a trade or investment restriction that is enhancing national security versus one that is unfairly protecting a U.S. ﬁ rm from foreign competition. The same dilemma regarding international trade and investment policies to protect national security in the United States also applies to all other countries.

Using Trade Policies for Political Reasons. International trade policy issues have become even more contentious over time as people have come to expect that trade policies will be used to punish countries for various actions. People expect countries to restrict imports from countries that fail to enforce environmental laws or child labor laws, initiate war against another country, or are unwilling to participate in a war against an unlawful dictator of another country. Every international trade convention now attracts a large number of protesters, all of whom have their own agendas. International trade may not even be the focus of each protest, but it is often thought to be the potential solution to the problem (at least in the mind of that protester). Although all of the protesters are clearly dissatisﬁed with existing trade policies, there is no consensus as to what trade policies should be. These different views are similar to the disagreements that occur between government representatives when they try to negotiate international trade policy. The managers of each MNC cannot be responsible for resolving these international trade policy conﬂ icts. However, they should at least recognize how a particular international trade policy affects their competitive position in the industry and how changes in policy could affect their position in the future.

Factors Affecting International Trade Flows Because international trade can signiﬁcantly affect a country’s economy, it is important to identify and monitor the factors that inﬂuence it. The most inﬂuential factors are: • Inflation • National income • Government policies • Exchange rates

H T T P : // http://www.census.gov Latest economic, ﬁnancial, socioeconomic, and political surveys and statistics.

H T T P : // http://research.stlouisfed .org/fred2 Information about international trade, international transactions, and the balance of trade.

Impact of Inflation If a country’s inﬂation rate increases relative to the countries with which it trades, its current account will be expected to decrease, other things being equal. Consumers and corporations in that country will most likely purchase more goods overseas (due to high local inﬂation), while the country’s exports to other countries will decline.

Impact of National Income If a country’s income level (national income) increases by a higher percentage than those of other countries, its current account is expected to decrease, other things being equal. As the real income level (adjusted for inﬂation) rises, so does consumption of goods. A percentage of that increase in consumption will most likely reﬂect an increased demand for foreign goods.

Chapter 2: International Flow of Funds

H T T P : // http://www.dataweb .usitc.gov Information about tariffs on imported products. Click on any country listed, and then click on Trade Regulations. Review the import controls set by that country’s government.

35

Impact of Government Policies A country’s government can have a major effect on its balance of trade due to its policies on subsidizing exporters, restrictions on imports, or lack of enforcement on piracy.

Subsidies for Exporters. Some governments offer subsidies to their domestic ﬁ rms, so that those ﬁ rms can produce products at a lower cost than their global competitors. Thus, the demand for the exports produced by those ﬁ rms is higher as a result of subsidies. Many firms in China commonly receive free loans or free land from the government. These firms incur a lower cost of operations and are able to price their products lower as a result, which enables them to capture a larger share of the global market. ■

E X A M P L E

H T T P : // http://www.worldbank .org/data/wdi2000/pdfs/ tab6_6.pdf Detailed information about tariffs imposed by each country.

H T T P : // http://www.commerce.gov General information about import restrictions and other trade-related information.

H T T P : // http://www.treas.gov/ofac An update of sanctions imposed by the U.S. government on speciﬁc countries.

Some subsidies are more obvious than others. It could be argued that every government provides subsidies in some form. A country’s government can prevent or discourage imports from other countries. By imposing such restrictions, the government disrupts trade ﬂows. Among the most commonly used trade restrictions are tariffs and quotas.

Restrictions on Imports. If a country’s government imposes a tax on imported goods (often referred to as a tariff), the prices of foreign goods to consumers are effectively increased. Tariffs imposed by the U.S. government are on average lower than those imposed by other governments. Some industries, however, are more highly protected by tariffs than others. American apparel products and farm products have historically received more protection against foreign competition through high tariffs on related imports. In addition to tariffs, a government can reduce its country’s imports by enforcing a quota, or a maximum limit that can be imported. Quotas have been commonly applied to a variety of goods imported by the United States and other countries.

Lack of Restrictions on Piracy. In some cases, a government can affect international trade ﬂows by its lack of restrictions on piracy. In China, piracy is very common. Individuals (called pirates) manufacture CDs and DVDs that look almost exactly like the original product produced in the United States and other countries. They sell the CDs and DVDs on the street at a price that is lower than the original product. They even sell the CDs and DVDs to retail stores. Consequently, local consumers obtain copies of imports rather than actual imports. According to the U.S. film industry, 90 percent of the DVDs that were the intellectual property of U.S. firms and purchased in China may be pirated. It has been estimated that U.S. producers of film, music, and software lose $2 billion in sales per year due to piracy in China. The Chinese government has periodically stated that it would attempt to crack down, but piracy is still prevalent. ■

E E X X A A M M P P L L E E

As a result of piracy, China’s demand for imports is lower. Piracy is one reason why the United States has a large balance-of-trade deﬁcit with China. However, even if piracy were eliminated, the U.S. trade deﬁcit with China would still be large.

Impact of Exchange Rates Each country’s currency is valued in terms of other currencies through the use of exchange rates, so that currencies can be exchanged to facilitate international trans-

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actions. The values of most currencies can ﬂuctuate over time because of market and government forces (as discussed in detail in Chapter 4). If a country’s currency begins to rise in value against other currencies, its current account balance should decrease, other things being equal. As the currency strengthens, goods exported by that country will become more expensive to the importing countries. As a consequence, the demand for such goods will decrease. A tennis racket that sells in the United States for $100 will require a payment of C$125 by the Canadian importer if the Canadian dollar is valued at C$1 $.80. If C$1 $.70, it would require a payment of C$143, which might discourage the Canadian demand for U.S. tennis rackets. A strong local currency is expected to reduce the current account balance if the traded goods are price-elastic (sensitive to price changes). ■

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Using the tennis racket example above, consider the possible effects if currencies of several countries depreciate simultaneously against the dollar (the dollar strengthens). The U.S. balance of trade can decline substantially. During the 1997–1998 Asian crisis, the exchange rates of Asian currencies declined substantially against the dollar, which caused the prices of Asian products to decline from the perspective of the United States and many other countries. Consequently, the demand for Asian products increased and sometimes replaced the demand for products of other countries. For example, the weakness of the Thai baht during this period caused an increase in the global demand for fish from Thailand and a decline in the demand for similar products from the United States (Seattle). ■

E E X X A A M M P P L L E E

Just as a strong dollar is expected to cause a more pronounced U.S. balanceof-trade deﬁcit as explained above, a weak dollar is expected to reduce the U.S. balance-of-trade deﬁcit. The dollar’s weakness lowers the price paid for U.S. goods by foreign customers and can lead to an increase in the demand for U.S. products. A weak dollar also tends to increase the dollar price paid for foreign goods and thus reduces the U.S. demand for foreign goods.

Interaction of Factors Because the factors that affect the balance of trade interact, their simultaneous inﬂuence on the balance of trade is complex. For example, as a high U.S. inﬂation rate reduces the current account, it places downward pressure on the value of the dollar (as discussed in detail in Chapter 4). Since a weaker dollar can improve the current account, it may partially offset the impact of inﬂation on the current account.

Correcting a Balance-of-Trade Deficit A balance-of-trade deﬁcit is not necessarily a problem, as it may enable a country’s consumers to beneﬁt from imported products that are less expensive than locally produced products. However, the purchase of imported products implies less reliance on domestic production in favor of foreign production. Thus, it may be argued that a large balance-of-trade deﬁcit causes a transfer of jobs to some foreign countries. Consequently, a country’s government may attempt to correct a balance-of-trade deﬁcit. By reconsidering some of the factors that affect the balance of trade, it is possible to develop some common methods for correcting a deﬁcit. Any policy that will increase foreign demand for the country’s goods and services will improve its balance-of-trade position. Foreign demand may increase if export prices become more attractive. This can occur when the country’s inﬂation is low or when its currency’s value is reduced, thereby making the prices cheaper from a foreign perspective.

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37

A ﬂoating exchange rate could possibly correct any international trade imbalances in the following way. A deﬁcit in a country’s balance of trade suggests that the country is spending more funds on foreign products than it is receiving from exports to foreign countries. Because it is selling its currency (to buy foreign goods) in greater volume than the foreign demand for its currency, the value of its currency should decrease. This decrease in value should encourage more foreign demand for its goods in the future. While this theory seems rational, it does not always work as just described. It is possible that, instead, a country’s currency will remain stable or appreciate even when the country has a balance-of-trade deﬁcit. The United States normally experiences a large balance-of-trade deficit, which should place downward pressure on the value of the dollar. Yet, in some years, there is substantial investment in dollar-denominated securities by foreign investors. This foreign demand for the dollar places upward pressure on its value, thereby offsetting the downward pressure caused by the trade imbalance. Thus, a balance-of-trade deficit will not always be corrected by a currency adjustment. ■

E X A M P L E

Why a Weak Home Currency Is Not a Perfect Solution Even if a country’s home currency weakens, its balance-of-trade deﬁcit will not necessarily be corrected for the following reasons.

Counterpricing by Competitors. When a country’s currency weakens, its prices become more attractive to foreign customers, and many foreign companies lower their prices to remain competitive with the country’s ﬁ rms.

Impact of Other Weak Currencies. The currency does not necessarily weaken against all currencies at the same time. Even if the dollar weakens in Europe, the dollar’s exchange rates with the currencies of Hong Kong, Singapore, South Korea, and Taiwan may remain more stable. As some U.S. firms reduce their demand for supplies produced in European countries, they tend to increase their demand for goods produced in Asian countries. Consequently, the dollar’s weakness in European countries causes a change in international trade behavior but does not eliminate the U.S. trade deficit. ■

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Prearranged International Transactions. Many international trade transactions are prearranged and cannot be immediately adjusted. Thus, exporters and importers are committed to continue the international transactions that they agreed to complete. Over time, non-U.S. ﬁ rms may begin to take advantage of the weaker dollar by purchasing U.S. imports, if they believe that the weakness will continue. The lag time between the dollar’s weakness and the non-U.S. ﬁ rms’ increased demand for U.S. products has sometimes been estimated to be 18 months or even longer. The U.S. balance of trade may actually deteriorate in the short run as a result of dollar depreciation, since U.S. importers would need more dollars to pay for the imports they contracted to purchase. The U.S. balance of trade only improves when U.S. and non-U.S. importers respond to the change in purchasing power that is caused by the weaker dollar. This pattern is called the J-curve effect, and it is illustrated in Exhibit 2.6. The further decline in the trade balance before a reversal creates a trend that can look like the letter J.

Part 1: The International Financial Environment Exhibit 2.6

U.S. Trade Balance

38

J-Curve Effect

0

J Curve

Time

Intracompany Trade. A fourth reason why a weak currency will not always improve a country’s balance of trade is that importers and exporters that are under the same ownership have unique relationships. Many ﬁ rms purchase products that are produced by their subsidiaries in what is referred to as intracompany trade. This type of trade makes up more than 50 percent of all international trade. The trade between the two parties will normally continue regardless of exchange rate movements. Thus, the impact of exchange rate movements on intracompany trade patterns is limited.

International Capital Flows One of the most important types of capital ﬂows is direct foreign investment. Firms commonly attempt to engage in direct foreign investment so that they can reach additional consumers or can rely on low-cost labor. In 2006, the total amount of direct foreign investment (by ﬁ rms or government agencies all over the world) into all countries was about $1.2 trillion. Exhibit 2.7 shows a distribution of the regions where the DFI was targeted during 2006. Notice that Europe attracted almost half of the total DFI in 2006. Western European countries attracted most of the DFI, but Eastern European countries such as Poland, Hungary, Slovenia, Croatia, and the Czech Republic also attracted a signiﬁcant amount of DFI. This is not surprising since these countries are not as developed as those in Western Europe and have more potential for growth. They also have relatively low wages. The United States attracted about $177 billion in DFI in 2006, or 14 percent of the total DFI.

Distribution of DFI by U.S. Firms Many U.S.-based MNCs have recently increased their DFI in foreign countries. For example, ExxonMobil, IBM, and Hewlett-Packard have at least 50 percent of their assets in foreign countries. The United Kingdom and Canada are the biggest targets. Europe as a whole receives more than 50 percent of all DFI by U.S. ﬁ rms. Another

Chapter 2: International Flow of Funds Exhibit 2.7

39

Distribution of Global DFI across Regions in 2006

Other 8% Latin America & Caribbean 8%

Africa 3%

U.S. 14%

Asia 19% Europe 48%

Source: United Nations.

30 percent of DFI is focused on Latin America and Canada, while about 16 percent is concentrated in the Asia and Paciﬁc region. The DFI by U.S. ﬁ rms in Latin American and Asian countries has increased substantially as these countries have opened their markets to U.S. ﬁ rms.

Distribution of DFI in the United States Just as U.S. ﬁ rms have used DFI to enter markets outside the United States, nonU.S. ﬁ rms have penetrated the U.S. market. Much of the DFI in the United States comes from the United Kingdom, Japan, the Netherlands, Germany, and Canada. Seagram, Food Lion, and some other foreign-owned MNCs generate more than half of their revenue from the United States. Many well-known ﬁ rms that operate in the United States are owned by foreign companies, including Shell Oil (Netherlands), Citgo Petroleum (Venezuela), Canon (Japan), and Fireman’s Fund (Germany). Many other ﬁ rms operating in the United States are partially owned by foreign companies, including MCI Communications (United Kingdom) and Northwest Airlines (Netherlands). While U.S.-based MNCs consider expanding in other countries, they must also compete with foreign ﬁ rms in the United States.

Factors Affecting DFI Capital ﬂows resulting from DFI change whenever conditions in a country change the desire of ﬁ rms to conduct business operations there. Some of the more common factors that could affect a country’s appeal for DFI are identiﬁed here.

Changes in Restrictions. During the 1990s, many countries lowered their restrictions on DFI, thereby opening the way to more DFI in those countries. Many U.S.-based MNCs, including Bausch & Lomb, Colgate-Palmolive, and General Electric, have been penetrating less developed countries such as Argentina, Chile, Mexico, India, China, and Hungary. New opportunities in these countries have arisen from the removal of government barriers.

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H T T P : // http://www.privatization.org Information about privatizations around the world, commentaries, and related publications.

Privatization. Several national governments have recently engaged in

privatization, or the selling of some of their operations to corporations and other investors.

Privatization is popular in Brazil and Mexico, in Eastern European countries such as Poland and Hungary, and in such Caribbean territories as the Virgin Islands. It allows for greater international business as foreign ﬁ rms can acquire operations sold by national governments. Privatization was used in Chile to prevent a few investors from controlling all the shares and in France to prevent a possible reversion to a more nationalized economy. In the United Kingdom, privatization was promoted to spread stock ownership across investors, which allowed more people to have a direct stake in the success of British industry. The primary reason that the market value of a ﬁ rm may increase in response to privatization is the anticipated improvement in managerial efﬁciency. Managers in a privately owned ﬁ rm can focus on the goal of maximizing shareholder wealth, whereas in a state-owned business, the state must consider the economic and social ramiﬁcations of any business decision. Also, managers of a privately owned enterprise are more motivated to ensure proﬁtability because their careers may depend on it. For these reasons, privatized ﬁ rms will search for local and global opportunities that could enhance their value. The trend toward privatization will undoubtedly create a more competitive global marketplace.

Potential Economic Growth. Countries that have greater potential for economic growth are more likely to attract DFI because ﬁ rms recognize that they may be able to capitalize on that growth by establishing more business there.

Tax Rates. Countries that impose relatively low tax rates on corporate earnings are more likely to attract DFI. When assessing the feasibility of DFI, ﬁ rms estimate the after-tax cash ﬂows that they expect to earn. Exchange Rates. Firms typically prefer to pursue DFI in countries where the local currency is expected to strengthen against their own. Under these conditions, they can invest funds to establish their operations in a country while that country’s currency is relatively cheap (weak). Then, earnings from the new operations can periodically be converted back to the ﬁ rm’s currency at a more favorable exchange rate.

Factors Affecting International Portfolio Investment The desire by individual or institutional investors to direct international portfolio investment to a speciﬁc country is inﬂuenced by the following factors.

Tax Rates on Interest or Dividends. Investors normally prefer to invest in a country where the taxes on interest or dividend income from investments are relatively low. Investors assess their potential after-tax earnings from investments in foreign securities.

Interest Rates. Portfolio investment can also be affected by interest rates. Money tends to ﬂow to countries with high interest rates, as long as the local currencies are not expected to weaken.

H T T P : // http://www.worldbank.org Information on capital ﬂows and international transactions.

Exchange Rates. When investors invest in a security in a foreign country, their return is affected by (1) the change in the value of the security and (2) the change in the value of the currency in which the security is denominated. If a country’s home currency is expected to strengthen, foreign investors may be willing to invest in the country’s securities to beneﬁt from the currency movement. Conversely, if

Chapter 2: International Flow of Funds

41

a country’s home currency is expected to weaken, foreign investors may decide to purchase securities in other countries. In a period such as 2006, U.S. investors that invested in foreign securities beneﬁted from the change in exchange rates. Since the foreign currencies strengthened against the dollar over time, the foreign securities were ultimately converted to more dollars when they were sold at the end of the year.

Impact of International Capital Flows The United States relies heavily on foreign capital in many ways. First, there is foreign investment in the United States to build manufacturing plants, ofﬁces, and other buildings. Second, foreign investors purchase U.S. debt securities issued by U.S. ﬁ rms and therefore serve as creditors to these ﬁ rms. Third, foreign investors purchase Treasury debt securities and therefore serve as creditors to the U.S. government. Foreign investors are especially attracted to the U.S. ﬁ nancial markets when the interest rate in their home country is substantially lower than that in the United States. For example, Japan’s annual interest rate has been close to 1 percent for several years because the supply of funds in its credit market has been very large. At the same time, Japan’s economy has been stagnant, so the demand for funds to support business growth has been limited. Given the low interest rates in Japan, many Japanese investors invested their funds in the United States to earn a higher interest rate. The impact of international capital ﬂows on the U.S. economy is shown in Exhibit 2.8. At a given point in time, the long-term interest rate in the United States is determined by the interaction between the supply of funds available in U.S. credit markets and the amount of funds demanded there. The supply curve S1 in the left graph reﬂects the supply of funds from domestic sources. If the United States relied solely on domestic sources for its supply, its equilibrium interest rate would be i1 and the level of business investment in the United States (shown in the right graph) would be BI1. But since the supply curve also includes the supply of funds from foreign sources (as shown in S 2), the equilibrium interest rate is i2. Because of the large

Exhibit 2.8

Impact of the International Flow of Funds on U.S. Interest Rates and Business Investment in the United States

S2

Long-term Interest Rate

Long-term Interest Rate

S1

i1 i2

i1 i2

D

Amount of Funds S 1 includes only domestic funds S 2 includes domestic and foreign funds supplied to the United States

BI 1 BI 2 Amount of Business Investment in the United States

42

Part 1: The International Financial Environment

amount of international capital ﬂows that are provided to the U.S. credit markets, interest rates in the United States are lower than what they would be otherwise. This allows for a lower cost of borrowing and therefore a lower cost of using capital. Consequently, the equilibrium level of business investment is BI2. Because of the lower interest rate, there are more business opportunities that deserve to be funded. Consider the long-term rate shown here as the cost of borrowing by the most creditworthy ﬁ rms. Other ﬁ rms would have to pay a premium above that rate. Without the international capital ﬂows, there would be less funding available in the United States across all risk levels, and the cost of funding would be higher regardless of the ﬁ rm’s risk level. This would reduce the amount of feasible business opportunities in the United States.

Does the United States Rely Too Much on Foreign Funds? If Japan and China stopped investing in U.S. debt securities, the U.S. interest rates would possibly rise, and investors from other countries would be attracted to the relatively high U.S. interest rate. Thus, the United States would still be able to obtain funding for its debt, but its interest rates (cost of borrowing) may be higher. In general, access to international funding has allowed more growth in the U.S. economy over time, but it also makes the United States more reliant on foreign investors for funding. The United States should be able to rely on substantial foreign funding in the future as long as the U.S. government and ﬁ rms are still perceived to be creditworthy. If that trust is ever weakened, the U.S. government and ﬁ rms would only be able to obtain foreign funding if they paid a higher interest rate to compensate for the risk (a risk premium).

Agencies That Facilitate International Flows A variety of agencies have been established to facilitate international trade and ﬁ nancial transactions. These agencies often represent a group of nations. A description of some of the more important agencies follows.

H T T P : // http://www.imf.org The latest international economic news, data, and surveys.

International Monetary Fund The United Nations Monetary and Financial Conference held in Bretton Woods, New Hampshire, in July 1944, was called to develop a structured international monetary system. As a result of this conference, the International Monetary Fund (IMF) was formed. The major objectives of the IMF, as set by its charter, are to (1) promote cooperation among countries on international monetary issues, (2) promote stability in exchange rates, (3) provide temporary funds to member countries attempting to correct imbalances of international payments, (4) promote free mobility of capital funds across countries, and (5) promote free trade. It is clear from these objectives that the IMF’s goals encourage increased internationalization of business. The IMF is overseen by a Board of Governors, composed of ﬁ nance ofﬁcers (such as the head of the central bank) from each of the 185 member countries. It also has an executive board composed of 24 executive directors representing the member countries. This board is based in Washington, D.C., and meets at least three times a week to discuss ongoing issues. One of the key duties of the IMF is its compensatory ﬁnancing facility (CFF), which attempts to reduce the impact of export instability on country economies. Although it is available to all IMF members, this facility is used mainly by developing countries. A country experiencing ﬁ nancial problems due to reduced export earnings must demonstrate that the reduction is temporary and beyond its control. In addition, it must be willing to work with the IMF in resolving the problem.

Chapter 2: International Flow of Funds

43

Each member country of the IMF is assigned a quota based on a variety of factors reﬂecting that country’s economic status. Members are required to pay this assigned quota. The amount of funds that each member can borrow from the IMF depends on its particular quota. The ﬁ nancing by the IMF is measured in special drawing rights (SDRs). The SDR is not a currency but simply a unit of account. It is an international reserve asset created by the IMF and allocated to member countries to supplement currency reserves. The SDR’s value ﬂuctuates in accordance with the value of major currencies. The IMF played an active role in attempting to reduce the adverse effects of the Asian crisis. In 1997 and 1998, it provided funding to various Asian countries in exchange for promises from the respective governments to take speciﬁc actions intended to improve economic conditions.

Funding Dilemma of the IMF. The IMF typically speciﬁes economic reforms that a country must satisfy to receive IMF funding. In this way, the IMF attempts to ensure that the country uses the funds properly. However, some countries want funding without adhering to the economic reforms required by the IMF. During the Asian crisis, the IMF agreed to provide $43 billion to Indonesia. The negotiations were tense, as the IMF demanded that President Suharto break up some of the monopolies run by his friends and family members and close some weak banks. Citizens of Indonesia interpreted the bank closures as a banking crisis and began to withdraw their deposits from all banks. In January 1998, the IMF demanded many types of economic reform, and Suharto agreed to them. The reforms may have been overly ambitious, however, and Suharto failed to institute them. The IMF agreed to renegotiate the terms in March 1998 in a continuing effort to rescue Indonesia, but this effort signaled that a country did not have to meet the terms of its agreement to obtain funding. A new agreement was completed in April, and the IMF resumed its payments to support a bailout of Indonesia. In May 1998, Suharto abruptly discontinued subsidies for gasoline and food, which led to riots. Suharto blamed the riots on the IMF and on foreign investors who wanted to acquire assets in Indonesia at depressed prices. ■

E X A M P L E

H T T P : // http://www.worldbank.org Website of the World Bank Group.

World Bank The International Bank for Reconstruction and Development (IBRD), also referred to as the World Bank, was established in 1944. Its primary objective is to make loans to countries to enhance economic development. For example, the World Bank recently extended a loan to Mexico for about $4 billion over a 10-year period for environmental projects to facilitate industrial development near the U.S. border. Its main source of funds is the sale of bonds and other debt instruments to private investors and governments. The World Bank has a proﬁt-oriented philosophy. Therefore, its loans are not subsidized but are extended at market rates to governments (and their agencies) that are likely to repay them. A key aspect of the World Bank’s mission is the Structural Adjustment Loan (SAL), established in 1980. The SALs are intended to enhance a country’s long-term economic growth. For example, SALs have been provided to Turkey and to some less developed countries that are attempting to improve their balance of trade. Because the World Bank provides only a small portion of the ﬁ nancing needed by developing countries, it attempts to spread its funds by entering into coﬁnancing agreements. Coﬁ nancing is performed in the following ways: • Official aid agencies. Development agencies may join the World Bank in financing development projects in low-income countries.

44

Part 1: The International Financial Environment

• Export credit agencies. The World Bank cofinances some capital-intensive projects that are also financed through export credit agencies. • Commercial banks. The World Bank has joined with commercial banks to provide financing for private-sector development. In recent years, more than 350 banks from all over the world have participated in cofinancing, including Bank of America, J.P. Morgan Chase, and Citigroup. The World Bank recently established the Multilateral Investment Guarantee Agency (MIGA), which offers various forms of political risk insurance. This is an additional means (along with its SALs) by which the World Bank can encourage the development of international trade and investment. The World Bank is one of the largest borrowers in the world; its borrowings have amounted to the equivalent of $70 billion. Its loans are well diversiﬁed among numerous currencies and countries. It has received the highest credit rating (AAA) possible.

World Trade Organization The World Trade Organization (WTO) was created as a result of the Uruguay Round of trade negotiations that led to the GATT accord in 1993. This organization was established to provide a forum for multilateral trade negotiations and to settle trade disputes related to the GATT accord. It began its operations in 1995 with 81 member countries, and more countries have joined since then. Member countries are given voting rights that are used to make judgments about trade disputes and other issues.

International Financial Corporation In 1956 the International Financial Corporation (IFC) was established to promote private enterprise within countries. Composed of a number of member nations, the IFC works to promote economic development through the private rather than the government sector. It not only provides loans to corporations but also purchases stock, thereby becoming part owner in some cases rather than just a creditor. The IFC typically provides 10 to 15 percent of the necessary funds in the private enterprise projects in which it invests, and the remainder of the project must be ﬁ nanced through other sources. Thus, the IFC acts as a catalyst, as opposed to a sole supporter, for private enterprise development projects. It traditionally has obtained ﬁ nancing from the World Bank but can borrow in the international ﬁ nancial markets.

International Development Association The International Development Association (IDA) was created in 1960 with country development objectives somewhat similar to those of the World Bank. Its loan policy is more appropriate for less prosperous nations, however. The IDA extends loans at low interest rates to poor nations that cannot qualify for loans from the World Bank.

H T T P : // http://www.bis.org Information on the role of the BIS and the various activities in which it is involved.

Bank for International Settlements The Bank for International Settlements (BIS) attempts to facilitate cooperation among countries with regard to international transactions. It also provides assistance to countries experiencing a ﬁ nancial crisis. The BIS is sometimes referred to as the “central banks’ central bank” or the “lender of last resort.” It played an important role in supporting some of the less developed countries during the international debt crisis in the early and mid-1980s. It commonly provides ﬁ nancing for central banks in Latin American and Eastern European countries.

Chapter 2: International Flow of Funds

H T T P : // http://www.oecd.org Summarizes the role and activities of the OECD.

45

Organization for Economic Cooperation and Development The Organization for Economic Cooperation and Development (OECD) facilitates governance in governments and corporations of countries with market economics. It has 30 member countries and has relationships with numerous countries. The OECD promotes international country relationships that lead to globalization.

Regional Development Agencies Several other agencies have more regional (as opposed to global) objectives relating to economic development. These include, for example, the Inter-American Development Bank (focusing on the needs of Latin America), the Asian Development Bank (established to enhance social and economic development in Asia), and the African Development Bank (focusing on development in African countries). In 1990, the European Bank for Reconstruction and Development was created to help the Eastern European countries adjust from communism to capitalism. Twelve Western European countries hold a 51 percent interest, while Eastern European countries hold a 13.5 percent interest. The United States is the biggest shareholder, with a 10 percent interest. There are 40 member countries in aggregate.

How International Trade Affects an MNC’s Value An MNC’s value can be affected by international trade in several ways. The cash ﬂows (and therefore the value) of an MNC’s subsidiaries that export to a speciﬁc country are typically expected to increase in response to a higher inﬂ ation rate (causing local substitutes to be more expensive) or a higher national income (which increases the level of spending) in that country. The expected cash ﬂows of the MNC’s subsidiaries that export or import may increase as a result of country trade agreements that reduce tariffs or other trade barriers. Cash ﬂows to a U.S.-based MNC that occur in the form of payments for exports manufactured in the United States are expected to increase as a result of a weaker dollar because the demand for its dollar-denominated exports should increase. However, cash ﬂows of U.S.-based importers may be reduced by a weaker dollar because it will take more dollars (increased cash outﬂows) to purchase the imports. A stronger dollar will have the opposite effects on cash ﬂows of U.S.-based MNCs involved in international trade.

SUMMARY ■ The key components of the balance of payments are the current account and the capital account. The current account is a broad measure of the country’s international trade balance. The capital account is a measure of the country’s long-term and short-term capital investments, including direct foreign investment and investment in securities (portfolio investment).

■ A country’s international trade ﬂows are affected by inﬂation, national income, government restrictions, and exchange rates. High inﬂation, a high national income, low or no restrictions on imports, and a strong local currency tend to result in a strong demand for imports and a current account deﬁcit. Although some countries attempt to correct cur-

46

Part 1: The International Financial Environment

rent account deﬁcits by reducing the value of their currencies, this strategy is not always successful. ■ A country’s international capital ﬂows are affected by any factors that inﬂuence direct foreign investment or portfolio investment. Direct foreign investment tends to occur in those countries that have

POINT

no restrictions and much potential for economic growth. Portfolio investment tends to occur in those countries where taxes are not excessive, where interest rates are high, and where the local currencies are not expected to weaken.

COUNTER-POINT

Should Trade Restrictions Be Used to Influence Human Rights Issues? Point Yes. Some countries do not protect human rights in the same manner as the United States. At times, the United States should threaten to restrict U.S. imports from or investment in a particular country if it does not correct human rights violations. The United States should use its large international trade and investment as leverage to ensure that human rights violations do not occur. Other countries with a history of human rights violations are more likely to honor human rights if their economic conditions are threatened. Counter-Point No. International trade and human rights are two separate issues. International trade should not be used as the weapon to enforce human rights. Firms engaged in international trade should not

SELF

be penalized by the human rights violations of a government. If the United States imposes trade restrictions to enforce human rights, the country will retaliate. Thus, the U.S. ﬁ rms that export to that foreign country will be adversely affected. By imposing trade sanctions, the U.S. government is indirectly penalizing the MNCs that are attempting to conduct business in speciﬁc foreign countries. Trade sanctions cannot solve every difference in beliefs or morals between the more developed countries and the developing countries. By restricting trade, the United States will slow down the economic progress of developing countries. Who Is Correct? Use the Internet to learn more about this issue. Which argument do you support? Offer your own opinion on this issue.

TEST

Answers are provided in Appendix A at the back of the text.

3. Explain how the Asian crisis affected trade between the United States and Asia.

1. Brieﬂy explain how changes in various economic factors affect the U.S. current account balance. 2. Explain why U.S. tariffs may change the composition of U.S. exports but will not necessarily reduce a U.S. balance-of-trade deﬁcit.

QUESTIONS

AND

1. Balance of Payments.

A P P L I CAT I O N S 2. Inﬂation Effect on Trade.

a. Of what is the current account generally

a. How would a relatively high home inﬂation rate

composed?

affect the home country’s current account, other things being equal?

b. Of what is the capital account generally

composed?

Chapter 2: International Flow of Funds b. Is a negative current account harmful to a

country? Discuss. 3. Government Restrictions. How can government restrictions affect international payments among countries? 4. IMF. a. What are some of the major objectives of

the IMF? b. How is the IMF involved in international

trade? 5. Exchange Rate Effect on Trade Balance. Would the U.S. balance-of-trade deﬁcit be larger or smaller if the dollar depreciates against all currencies, versus depreciating against some currencies but appreciating against others? Explain. 6. Demand for Exports. A relatively small U.S. balance-of-trade deﬁcit is commonly attributed to a strong demand for U.S. exports. What do you think is the underlying reason for the strong demand for U.S. exports?

Advanced Questions 11. Free Trade. There has been considerable momentum to reduce or remove trade barriers in an effort to achieve “free trade.” Yet, one disgruntled executive of an exporting ﬁ rm stated, “Free trade is not conceivable; we are always at the mercy of the exchange rate. Any country can use this mechanism to impose trade barriers.” What does this statement mean? 12. International Investments. U.S.-based MNCs commonly invest in foreign securities. a. Assume that the dollar is presently weak and is

expected to strengthen over time. How will these expectations affect the tendency of U.S. investors to invest in foreign securities? b. Explain how low U.S. interest rates can affect the

tendency of U.S.-based MNCs to invest abroad. c. In general terms, what is the attraction of foreign

investments to U.S. investors? 13. Exchange Rate Effects on Trade.

7. Change in International Trade Volume. Why do you think international trade volume has increased over time? In general, how are inefﬁcient ﬁ rms affected by the reduction in trade restrictions among countries and the continuous increase in international trade?

a. Explain why a stronger dollar could enlarge

the U.S. balance-of-trade deﬁcit. Explain why a weaker dollar could affect the U.S. balanceof-trade deﬁcit. b. It is sometimes suggested that a ﬂoating ex-

change rate will adjust to reduce or eliminate any current account deﬁcit. Explain why this adjustment would occur.

8. Effects of the Euro. Explain how the existence of the euro may affect U.S. international trade. 9. Currency Effects. When South Korea’s export growth stalled, some South Korean ﬁ rms suggested that South Korea’s primary export problem was the weakness in the Japanese yen. How would you interpret this statement? 10. Effects of Tariffs. Assume a simple world in which the United States exports soft drinks and beer to France and imports wine from France. If the United States imposes large tariffs on the French wine, explain the likely impact on the values of the U.S. beverage ﬁ rms, U.S. wine producers, the French beverage ﬁ rms, and the French wine producers.

BLADES,

INC.

47

c. Why does the exchange rate not always adjust to

a current account deﬁcit? Discussion in the Boardroom This exercise can be found in Appendix E at the back of this textbook. Running Your Own MNC This exercise can be found on the Xtra! website at http://maduraxtra.swlearning.com.S E

CASE

Exposure to International Flow of Funds Ben Holt, chief ﬁ nancial ofﬁcer (CFO) of Blades, Inc., has decided to counteract the decreasing demand for “Speedos” roller blades by exporting this product to Thailand. Furthermore, due to the low cost of rub-

ber and plastic in Southeast Asia, Holt has decided to import some of the components needed to manufacture “Speedos” from Thailand. Holt feels that importing rubber and plastic components from Thailand will

48

Part 1: The International Financial Environment

provide Blades with a cost advantage (the components imported from Thailand are about 20 percent cheaper than similar components in the United States). Currently, approximately $20 million, or 10 percent, of Blades’ sales are contributed by its sales in Thailand. Only about 4 percent of Blades’ cost of goods sold is attributable to rubber and plastic imported from Thailand. Blades faces little competition in Thailand from other U.S. roller blades manufacturers. Those competitors that export roller blades to Thailand invoice their exports in U.S. dollars. Currently, Blades follows a policy of invoicing in Thai baht (Thailand’s currency). Ben Holt felt that this strategy would give Blades a competitive advantage, since Thai importers can plan more easily when they do not have to worry about paying differing amounts due to currency ﬂuctuations. Furthermore, Blades’ primary customer in Thailand (a retail store) has committed itself to purchasing a certain amount of “Speedos” annually if Blades will invoice in baht for a period of three years. Blades’ purchases of components from Thai exporters are currently invoiced in Thai baht. Ben Holt is rather content with current arrangements and believes the lack of competitors in Thailand, the quality of Blades’ products, and its approach to pricing will ensure Blades’ position in the Thai roller blade market in the future. Holt also feels that Thai importers will prefer Blades over its competitors because Blades invoices in Thai baht. You, Blades’ ﬁ nancial analyst, have doubts as to Blades’ “guaranteed” future success. Although you believe Blades’ strategy for its Thai sales and imports is sound, you are concerned about current expecta-

SMALL

BUSINESS

tions for the Thai economy. Current forecasts indicate a high level of anticipated inﬂation, a decreasing level of national income, and a continued depreciation of the Thai baht. In your opinion, all of these future developments could affect Blades ﬁ nancially given the company’s current arrangements with its suppliers and with the Thai importers. Both Thai consumers and ﬁ rms might adjust their spending habits should certain developments occur. In the past, you have had difﬁculty convincing Ben Holt that problems could arise in Thailand. Consequently, you have developed a list of questions for yourself, which you plan to present to the company’s CFO after you have answered them. Your questions are listed here: 1. How could a higher level of inﬂation in Thailand affect Blades (assume U.S. inﬂation remains constant)? 2. How could competition from ﬁ rms in Thailand and from U.S. ﬁ rms conducting business in Thailand affect Blades? 3. How could a decreasing level of national income in Thailand affect Blades? 4. How could a continued depreciation of the Thai baht affect Blades? How would it affect Blades relative to U.S. exporters invoicing their roller blades in U.S. dollars? 5. If Blades increases its business in Thailand and experiences serious ﬁ nancial problems, are there any international agencies that the company could approach for loans or other ﬁ nancial assistance?

DILEMMA

Identifying Factors That Will Affect the Foreign Demand at the Sports Exports Company Recall from Chapter 1 that Jim Logan planned to pursue his dream of establishing his own business (called the Sports Exports Company) of exporting footballs to one or more foreign markets. Jim has decided to initially pursue the market in the United Kingdom because British citizens appear to have some interest in football as a possible hobby, and no other ﬁ rm has capitalized on this idea in the United Kingdom. (The sporting goods shops in the United Kingdom do not sell footballs but might be willing to sell them.) Jim has contacted one sporting goods distributor that has agreed to purchase footballs on a monthly basis and distribute (sell) them to sporting goods stores throughout the United Kingdom. The distributor’s demand

for footballs is ultimately inﬂuenced by the demand for footballs by British citizens who shop in British sporting goods stores. The Sports Exports Company will receive British pounds when it sells the footballs to the distributor and will then convert the pounds into dollars. Jim recognizes that products (such as the footballs his ﬁ rm will produce) exported from U.S. ﬁ rms to foreign countries can be affected by various factors. Identify the factors that affect the current account balance between the United States and the United Kingdom. Explain how each factor may possibly affect the British demand for the footballs that are produced by the Sports Exports Company.

Chapter 2: International Flow of Funds

I N T E R N E T/ E XC E L The website address of the Bureau of Economic Analysis is http://www.bea.gov. 1. Use this website to assess recent trends in exporting and importing by U.S. ﬁ rms. How has the balance of trade changed over the last 12 months? 2. Offer possible reasons for this change in the balance of trade. 3. Go to http://www.census.gov/foreign-trade/ balance/ and obtain monthly balance-of-trade data for the last 24 months between the United States and the United Kingdom or a country speciﬁed by your professor. Create an electronic spreadsheet in which the ﬁ rst column is the month of concern, and the second column is the trade balance. (See Appendix C for help with conducting analyses with Excel.) Use a compute statement to derive the percentage change in the trade balance in the third column. Then go to http://www.oanda.com/ convert/fxhistory. Obtain the direct exchange rate (dollars per currency unit) of the British pound (or

49

EXERCISES the local currency of the foreign country you select). Obtain the direct exchange rate of the currency at the beginning of each month and insert the data in column 4. Use a compute statement to derive the percentage change in the currency value from one month to the next in column 5. Then apply regression analysis in which the percentage change in the trade balance is the dependent variable and the percentage change in the exchange rate is the independent variable. Is there a signiﬁcant relationship between the two variables? Is the direction of the relationship as expected? If you think that the exchange rate movements affect the trade balance with a lag (because the transactions of importers and exporters may be booked a few months in advance), you can reconﬁgure your data to assess that relationship (match each monthly percentage change in the balance of trade with the exchange rate movement that occurred a few months earlier).

3: International Financial Markets Due to growth in international business over the last 30 years, various international ﬁnancial markets have been developed. Financial managers of MNCs must understand the various international ﬁnancial markets that are available so that they can use those markets to facilitate their international business transactions.

The specific objectives of this chapter are to describe the background and corporate use of the following international financial markets: ■ foreign exchange market, ■ international money market, ■ international credit market, ■ international bond market, and ■ international stock markets.

Foreign Exchange Market The foreign exchange market allows for the exchange of one currency for another. Large commercial banks serve this market by holding inventories of each currency, so that they can accommodate requests by individuals or MNCs. Individuals rely on the foreign exchange market when they travel to foreign countries. People from the United States exchange dollars for Mexican pesos when they visit Mexico, or euros when they visit Italy, or Japanese yen when they visit Japan. Some MNCs based in the United States exchange dollars for Mexican pesos when they purchase supplies in Mexico that are denominated in pesos, or euros when they purchase supplies from Italy that are denominated in euros. Other MNCs based in the United States receive Japanese yen when selling products to Japan and may wish to convert the yen to dollars. For one currency to be exchanged for another currency, there needs to be an exchange rate that speciﬁes the rate at which one currency can be exchanged for another. The exchange rate of the Mexican peso will determine how many dollars you need to stay in a hotel in Mexico City that charges 500 Mexican pesos per night. The exchange rate of the Mexican peso will also determine how many dollars an MNC will need to purchase supplies that are invoiced at 1 million pesos. The system for establishing exchange rates has changed over time, as described below.

History of Foreign Exchange The system used for exchanging foreign currencies has evolved from the gold standard, to an agreement on ﬁ xed exchange rates, to a ﬂoating rate system.

Gold Standard. From 1876 to 1913, exchange rates were dictated by the gold standard. Each currency was convertible into gold at a speciﬁed rate. Thus, the exchange rate between two currencies was determined by their relative convertibility rates per ounce of gold. Each country used gold to back its currency.

50

Chapter 3: International Financial Markets

51

When World War I began in 1914, the gold standard was suspended. Some countries reverted to the gold standard in the 1920s but abandoned it as a result of a banking panic in the United States and Europe during the Great Depression. In the 1930s, some countries attempted to peg their currency to the dollar or the British pound, but there were frequent revisions. As a result of the instability in the foreign exchange market and the severe restrictions on international transactions during this period, the volume of international trade declined.

Agreements on Fixed Exchange Rates. In 1944, an international agreement (known as the Bretton Woods Agreement) called for ﬁ xed exchange rates between currencies. This agreement lasted until 1971. During this period, governments would intervene to prevent exchange rates from moving more than 1 percent above or below their initially established levels. By 1971, the U.S. dollar appeared to be overvalued; the foreign demand for U.S. dollars was substantially less than the supply of dollars for sale (to be exchanged for other currencies). Representatives from the major nations met to discuss this dilemma. As a result of this conference, which led to the Smithsonian Agreement, the U.S. dollar was devalued relative to the other major currencies. The degree to which the dollar was devalued varied with each foreign currency. Not only was the dollar’s value reset, but exchange rates were also allowed to ﬂuctuate by 2.25 percent in either direction from the newly set rates. This was the ﬁ rst step in letting market forces (supply and demand) determine the appropriate price of a currency. Although boundaries still existed for exchange rates, they were widened, allowing the currency values to move more freely toward their appropriate levels. Floating Exchange Rate System. Even after the Smithsonian Agreement, governments still had difﬁculty maintaining exchange rates within the stated boundaries. By March 1973, the more widely traded currencies were allowed to ﬂuctuate in accordance with market forces, and the ofﬁcial boundaries were eliminated.

Foreign Exchange Transactions The “foreign exchange market” should not be thought of as a speciﬁc building or location where traders exchange currencies. Companies normally exchange one currency for another through a commercial bank over a telecommunications network.

H T T P : // http://www.oanda.com Historical exchange rate movements. Data are available on a daily basis for most currencies.

Spot Market. The most common type of foreign exchange transaction is for immediate exchange at the so-called spot rate. The market where these transactions occur is known as the spot market. The average daily foreign exchange trading by banks around the world now exceeds $1.5 trillion. The average daily foreign exchange trading in the United States alone exceeds $200 billion. Spot Market Structure. Hundreds of banks facilitate foreign exchange transactions, but the top 20 handle about 50 percent of the transactions. Deutsche Bank (Germany), Citibank (a subsidiary of Citigroup, U.S.), and J.P. Morgan Chase are the largest traders of foreign exchange. Some banks and other ﬁ nancial institutions have formed alliances (one example is FX Alliance LLC) to offer currency transactions over the Internet. Banks in London, New York, and Tokyo, the three largest foreign exchange trading centers, conduct much of the foreign exchange trading. Yet, many foreign exchange transactions occur outside these trading centers. Banks in virtually every major city facilitate foreign exchange transactions between MNCs. Commercial transactions

52

Part 1: The International Financial Environment

between countries are often done electronically, and the exchange rate at the time determines the amount of funds necessary for the transaction. Indiana Co. purchases supplies priced at 100,000 euros (€) from Belgo, a Belgian supplier, on the first day of every month. Indiana instructs its bank to transfer funds from its account to the supplier’s account on the first day of each month. It only has dollars in its account, whereas Belgo’s account is in euros. When payment was made one month ago, the euro was worth $1.08, so Indiana Co. needed $108,000 to pay for the supplies (€100,000 $1.08 $108,000). The bank reduced Indiana’s account balance by $108,000, which was exchanged at the bank for €100,000. The bank then sent the €100,000 electronically to Belgo by increasing Belgo’s account balance by €100,000. Today, a new payment needs to be made. The euro is currently valued at $1.12, so the bank will reduce Indiana’s account balance by $112,000 (€100,000 $1.12 $112,000) and exchange it for €100,000, which will be sent electronically to Belgo. The bank not only executes the transactions but also serves as the foreign exchange dealer. Each month the bank receives dollars from Indiana Co. in exchange for the euros it provides. In addition, the bank facilitates other transactions for MNCs in which it receives euros in exchange for dollars. The bank maintains an inventory of euros, dollars, and other currencies to facilitate these foreign exchange transactions. If the transactions cause it to buy as many euros as it sells to MNCs, its inventory of euros will not change. If the bank sells more euros than it buys, however, its inventory of euros will be reduced. ■

E X A M P L E

If a bank begins to experience a shortage in a particular foreign currency, it can purchase that currency from other banks. This trading between banks occurs in what is often referred to as the interbank market. Within this market, banks can obtain quotes, or they can contact brokers who sometimes act as intermediaries, matching one bank desiring to sell a given currency with another bank desiring to buy that currency. About 10 foreign exchange brokerage ﬁ rms handle much of the interbank transaction volume. Other intermediaries also serve the foreign exchange market. Some other ﬁ nancial institutions such as securities ﬁ rms can provide the same services described in the previous example. In addition, most major airports around the world have foreign exchange centers, where individuals can exchange currencies. In many cities, there are retail foreign exchange ofﬁces where tourists and other individuals can exchange currencies. Some MNCs rely on an online currency trader that serves as an intermediary between the MNC and member banks. One popular online currency trader is Currenex, which conducts more than $300 million in foreign exchange transactions per day. If an MNC needs to purchase a foreign currency, it logs on and speciﬁes its order. Currenex relays the order to various banks that are members of its system and are allowed to bid for the orders. When Currenex relays the order, member banks have a very short time (such as 25 seconds) to specify a quote online for the currency that the customer (the MNC) desires. Then, Currenex displays the quotes on a screen, ranked from highest to lowest. The MNC has about 5 seconds to select one of the quotes provided, and the deal is completed. This process is much more transparent than traditional foreign exchange market transactions because the MNC can review quotes of many competitors at one time. By enabling the MNC to make sure that it does not overpay for a currency, this system enhances the MNC’s value.

Use of the Dollar in the Spot Market. Many foreign transactions do not require an exchange of currencies but allow a given currency to cross country borders. For example, the U.S. dollar is commonly accepted as a medium of exchange by merchants in many countries, especially in countries such as Bolivia, Indonesia,

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Russia, and Vietnam where the home currency is either weak or subject to foreign exchange restrictions. Many merchants accept U.S. dollars because they can use them to purchase goods from other countries. The U.S. dollar is the ofﬁcial currency of Ecuador, Liberia, and Panama. Yet, the U.S. dollar is not part of every transaction. Foreign currencies can be traded for each other. For example, a Japanese ﬁ rm may need British pounds to pay for imports from the United Kingdom.

Spot Market Time Zones. Although foreign exchange trading is conducted only during normal business hours in a given location, these hours vary among locations due to different time zones. Thus, at any given time on a weekday, somewhere around the world a bank is open and ready to accommodate foreign exchange requests. When the foreign exchange market opens in the United States each morning, the opening exchange rate quotations are based on the prevailing rates quoted by banks in London and other locations where the foreign exchange markets have opened earlier. Suppose the quoted spot rate of the British pound was $1.80 at the previous close of the U.S. foreign exchange market, but by the time the market opens the following day, the opening spot rate is $1.76. News occurring in the morning before the U.S. market opened could have changed the supply and demand conditions for British pounds in the London foreign exchange market, reducing the quoted price for the pound. With the newest electronic devices, foreign currency trades are negotiated on computer terminals, and a push of a button conﬁ rms the trade. Traders now use electronic trading boards that allow them to instantly register transactions and check their bank’s positions in various currencies. Also, several U.S. banks have established night trading desks. The largest banks initiated night trading to capitalize on foreign exchange movements at night and to accommodate corporate requests for currency trades. Even some medium-sized banks now offer night trading to accommodate corporate clients.

Spot Market Liquidity. The spot market for each currency can be described by its liquidity, which reﬂects the level of trading activity. The more willing buyers and sellers there are, the more liquid a market is. The spot markets for heavily traded currencies such as the euro, the British pound, and the Japanese yen are very liquid. Conversely, the spot markets for currencies of less developed countries are less liquid. A currency’s liquidity affects the ease with which an MNC can obtain or sell that currency. If a currency is illiquid, the number of willing buyers and sellers is limited, and an MNC may be unable to quickly purchase or sell that currency at a reasonable exchange rate. Attributes of Banks That Provide Foreign Exchange. The following characteristics of banks are important to customers in need of foreign exchange: 1. Competitiveness of quote. A savings of 1¢ per unit on an order of one million units of currency is worth $10,000. 2. Special relationship with the bank. The bank may offer cash management services or be willing to make a special effort to obtain even hard-to-ﬁ nd foreign currencies for the corporation. 3. Speed of execution. Banks may vary in the efﬁciency with which they handle an order. A corporation needing the currency will prefer a bank that conducts the transaction promptly and handles any paperwork properly.

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Part 1: The International Financial Environment

H T T P : // http://www.everbank.com Individuals can open an FDIC-insured CD account in a foreign currency.

4. Advice about current market conditions. Some banks may provide assessments of foreign economies and relevant activities in the international ﬁ nancial environment that relate to corporate customers. 5. Forecasting advice. Some banks may provide forecasts of the future state of foreign economies and the future value of exchange rates. This list suggests that a corporation needing a foreign currency should not automatically choose a bank that will sell that currency at the lowest price. Most corporations that often need foreign currencies develop a close relationship with at least one major bank in case they ever need favors from a bank.

Foreign Exchange Quotations H T T P : //

Spot Market Interaction among Banks. At any given point in

http://www.xe.com/fx Allows individuals to buy and sell currencies.

time, the exchange rate between two currencies should be similar across the various banks that provide foreign exchange services. If there is a large discrepancy, customers or other banks will purchase large amounts of a currency from whatever bank quotes a relatively low price and immediately sell it to whatever bank quotes a relatively high price. Such actions cause adjustments in the exchange rate quotations that eliminate any discrepancy.

Bid/Ask Spread of Banks. Commercial banks charge fees for conducting foreign exchange transactions. At any given point in time, a bank’s bid (buy) quote for a foreign currency will be less than its ask (sell) quote. The bid/ask spread represents the differential between the bid and ask quotes and is intended to cover the costs involved in accommodating requests to exchange currencies. The bid/ask spread is normally expressed as a percentage of the ask quote. To understand how a bid/ask spread could affect you, assume you have $1,000 and plan to travel from the United States to the United Kingdom. Assume further that the bank’s bid rate for the British pound is $1.52 and its ask rate is $1.60. Before leaving on your trip, you go to this bank to exchange dollars for pounds. Your $1,000 will be converted to 625 pounds (£), as follows:

E X A M P L E

$1,000 Amount of U.S. dollars to be converted £625 5 $1.60 Price charged by bank per pound

H T T P : // http://www.sonnetﬁnancial .com/rates/full.asp Bid and ask quotations for all major currencies. This website provides exchange rates for many currencies. The table can be customized to focus on the currencies of interest to you.

Now suppose that because of an emergency you cannot take the trip, and you reconvert the £625 back to U.S. dollars, just after purchasing the pounds. If the exchange rate has not changed, you will receive

£625 (Bank’s bid rate of $1.52 per pound) $950 Due to the bid/ask spread, you have $50 (5 percent) less than what you started with. Obviously, the dollar amount of the loss would be larger if you originally converted more than $1,000 into pounds. ■

Comparison of Bid/Ask Spread among Currencies. The differential between a bid quote and an ask quote will look much smaller for currencies that have a smaller value. This differential can be standardized by measuring it as a percentage of the currency’s spot rate. Charlotte Bank quotes a bid price for yen of $.007 and an ask price of $.0074. In this case, the nominal bid/ask spread is $.0074 $.007, or just four-hundredths of a penny. Yet, the bid/ask spread in percentage terms is actually slightly higher for the yen in this example

E X A M P L E

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than for the pound in the previous example. To prove this, consider a traveler who sells $1,000 for yen at the bank’s ask price of $.0074. The traveler receives about ¥135,135 (computed as $1,000/$.0074). If the traveler cancels the trip and converts the yen back to dollars, then, assuming no changes in the bid/ask quotations, the bank will buy these yen back at the bank’s bid price of $.007 for a total of about $946 (computed by ¥135,135 $.007), which is $54 (or 5.4 percent) less than what the traveler started with. This spread exceeds that of the British pound (5 percent in the previous example). ■

A common way to compute the bid/ask spread in percentage terms follows: Bid/ask spread 5

Ask rate 2 Bid rate Ask rate

Using this formula, the bid/ask spreads are computed in Exhibit 3.1 for both the British pound and the Japanese yen. Notice that these numbers coincide with those derived earlier. Such spreads are common for so-called retail transactions serving consumers. For larger so-called wholesale transactions between banks or for large corporations, the spread will be much smaller. The bid/ask spread for small retail transactions is commonly in the range of 3 to 7 percent; for wholesale transactions requested by MNCs, the spread is between .01 and .03 percent. The spread is normally larger for illiquid currencies that are less frequently traded. Commercial banks are normally exposed to more exchange rate risk when maintaining these currencies. The bid/ask spread as deﬁ ned here represents the discount in the bid rate as a percentage of the ask rate. An alternative bid/ask spread uses the bid rate as the denominator instead of the ask rate and measures the percentage markup of the ask rate above the bid rate. The spread is slightly higher when using this formula because the bid rate used in the denominator is always less than the ask rate. In the following discussion and in examples throughout much of the text, the bid/ask spread will be ignored. That is, only one price will be shown for a given currency to allow you to concentrate on understanding other relevant concepts. These examples depart slightly from reality because the bid and ask prices are, in a sense, assumed to be equal. Although the ask price will always exceed the bid price by a small amount in reality, the implications from examples should nevertheless hold, even though the bid/ask spreads are not accounted for. In particular examples where the bid/ask spread can contribute signiﬁcantly to the concept, it will be accounted for. Various websites, including bloomberg.com, provide bid/ask quotations. To conserve space, some quotations show the entire bid price followed by a slash and then only the last two or three digits of the ask price.

E X A M P L E

Assume that the prevailing quote for wholesale transactions by a commercial bank for the euro is $1.0876/78. This means that the commercial bank is willing to pay

Exhibit 3.1

Currency

Computation of the Bid/Ask Spread

Bid Rate

Ask Rate

Ask Rate Bid Rate Ask Rate

British pound

$1.52

$1.60

$1.60 $1.52 $1.60

Japanese yen

$.0070

$.0074

$.0074 $.007 $.0074

Bid/Ask Percentage Spread

.05 or 5%

.054 or 5.4%

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Part 1: The International Financial Environment $1.0876 per euro. Alternatively, it is willing to sell euros for $1.0878. The bid/ask spread in this example is:

Bid/ask spread 5

$1.0878 2 $1.0876 $1.0878

5 about .000184 or .0184%

■

Factors That Affect the Spread. The spread on currency quotations is inﬂuenced by the following factors: Spread f(Order costs, Inventory costs, Competition, Volume, Currency risk)

• Order costs. Order costs are the costs of processing orders, including clearing costs and the costs of recording transactions. • Inventory costs. Inventory costs are the costs of maintaining an inventory of a particular currency. Holding an inventory involves an opportunity cost because the funds could have been used for some other purpose. If interest rates are relatively high, the opportunity cost of holding an inventory should be relatively high. The higher the inventory costs, the larger the spread that will be established to cover these costs. • Competition. The more intense the competition, the smaller the spread quoted by intermediaries. Competition is more intense for the more widely traded currencies because there is more business in those currencies. • Volume. More liquid currencies are less likely to experience a sudden change in price. Currencies that have a large trading volume are more liquid because there are numerous buyers and sellers at any given time. This means that the market has sufﬁcient depth that a few large transactions are unlikely to cause the currency’s price to change abruptly. • Currency risk. Some currencies exhibit more volatility than others because of economic or political conditions that cause the demand for and supply of the currency to change abruptly. For example, currencies in countries that have frequent political crises are subject to abrupt price movements. Intermediaries that are willing to buy or sell these currencies could incur large losses due to an abrupt change in the values of these currencies.

Interpreting Foreign Exchange Quotations Exchange rate quotations for widely traded currencies are published in The Wall Street Journal and in business sections of many newspapers on a daily basis. With some exceptions, each country has its own currency. In 1999, several European countries (including Germany, France, and Italy) adopted the euro as their new currency for commercial transactions, replacing their own currencies. Their own currencies were phased out in 2002.

Direct versus Indirect Quotations. The quotations of exchange rates for currencies normally reﬂect the ask prices for large transactions. Since exchange rates change throughout the day, the exchange rates quoted in a newspaper reﬂect only one speciﬁc point in time during the day. Quotations that represent the value of a foreign currency in dollars (number of dollars per currency) are referred to as direct quotations. Conversely, quotations that represent the number of units of a foreign currency per dollar are referred to as indirect quotations. The indirect quotation is the reciprocal of the corresponding direct quotation.

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The spot rate of the euro is quoted this morning at $1.031. This is a direct quotation, as it represents the value of the foreign currency in dollars. The indirect quotation of the euro is the reciprocal of the direct quotation:

E X X A M P L E

Indirect quotation 5 1/Direct quotation 5 1/$1.031 5 .97, which means .97 euros 5 $1 If you initially received the indirect quotation, you can take the reciprocal of it to obtain the direct quote. Since the indirect quotation for the euro is $.97, the direct quotation is:

Direct quotation 5 1/Indirect quotation 5 1/.97 5 $1.031

■

A comparison of direct and indirect exchange rates for two points in time appears in Exhibit 3.2. Columns 2 and 3 provide quotes at the beginning of the semester, while columns 4 and 5 provide quotes at the end of the semester. For each currency, the indirect quotes at the beginning and end of the semester (columns 3 and 5) are the reciprocals of the direct quotes at the beginning and end of the semester (columns 2 and 4). The exhibit illustrates how the indirect quotation adjusts in response to changes in the direct quotation. Based on Exhibit 3.2, the Canadian dollar’s direct quotation changed from $.66 to $.70 over the semester. This change reflects an appreciation of the Canadian dollar, as the currency’s value increased over the semester. Notice that the Canadian dollar’s indirect quotation decreased from 1.51 to 1.43 over the semester. This means that it takes fewer Canadian dollars to obtain a U.S. dollar at the end of the semester than it took at the beginning. This change also confirms that the Canadian dollar’s value has strengthened, but it can be confusing because the decline in the indirect quote over time reflects an appreciation of the currency. Notice that the Mexican peso’s direct quotation changed from $.12 to $.11 over the semester. This reflects a depreciation of the peso. The indirect quotation increased over the semester, which means that it takes more pesos at the end of the semester to obtain a U.S. dollar than it took at the beginning. This change also confirms that the peso has depreciated over the semester. ■

E X A M P L E

Exhibit 3.2 (1)

Currency Canadian dollar

Direct and Indirect Exchange Rate Quotations (2) Direct Quotation as of Beginning of Semester

(3) Indirect Quotation (number of units per dollar) as of Beginning of Semester

(4) Direct Quotation as of End of Semester

(5) Indirect Quotation (number of units per dollar) as of End of Semester

$.66

1.51

$.70

1.43

$1.031

.97

$1.064

.94

Japanese yen

$.009

111.11

Mexican peso

$.12

8.33

$.11

9.09

Swiss franc

$.62

1.61

$.67

1.49

U.K. pound

$1.50

.67

$1.60

.62

Euro

$.0097

103.09

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Part 1: The International Financial Environment

The examples illustrate that the direct and indirect quotations for a given currency move in opposite directions over a particular period. This relationship should be obvious by now: As one quotation moves in one direction, the reciprocal of that quotation must move in the opposite direction. If you are doing any extensive analysis of exchange rates, you should ﬁ rst convert all exchange rates into direct quotations. In this way, you can more easily compare currencies and are less likely to make a mistake in determining whether a currency is appreciating or depreciating over a particular period. Discussions of exchange rate movements can be confusing if some comments refer to direct quotations while others refer to indirect quotations. For consistency, this text uses direct quotations unless an example can be clariﬁed by the use of indirect quotations. Direct quotations are easier to link with comments about any foreign currency.

Cross Exchange Rates. Most tables of exchange rate quotations express currencies relative to the dollar, but in some instances, a ﬁ rm will be concerned about the exchange rate between two nondollar currencies. For example, if a Canadian ﬁ rm needs Mexican pesos to buy Mexican goods, it wants to know the Mexican peso value relative to the Canadian dollar. The type of rate desired here is known as a cross exchange rate, because it reﬂects the amount of one foreign currency per unit of another foreign currency. Cross exchange rates can be easily determined with the use of foreign exchange quotations. The value of any nondollar currency in terms of another is its value in dollars divided by the other currency’s value in dollars.

E X A M P L E H T T P : // http://www.bloomberg.com Cross exchange rates for several currencies.

If the peso is worth $.07, and the Canadian dollar is worth $.70, the value of the peso in Canadian dollars (C$) is calculated as follows:

Value of peso in C$ 5

Value of peso in $ Value of C$ in $

5

$.07 5 C$.10 $.70

Thus, a Mexican peso is worth C$.10. The exchange rate can also be expressed as the number of pesos equal to one Canadian dollar. This figure can be computed by taking the reciprocal: .70/.07 = 10.0, which indicates that a Canadian dollar is worth 10.0 pesos according to the information provided. ■

Forward, Futures, and Options Markets Forward Contracts. In addition to the spot market, a forward market for currencies enables an MNC to lock in the exchange rate (called a forward rate) at which it will buy or sell a currency. A forward contract speciﬁes the amount of a particular currency that will be purchased or sold by the MNC at a speciﬁed future point in time and at a speciﬁed exchange rate. Commercial banks accommodate the MNCs that desire forward contracts. MNCs commonly use the forward market to hedge future payments that they expect to make or receive in a foreign currency. In this way, they do not have to worry about ﬂuctuations in the spot rate until the time of their future payments. Memphis Co. has ordered supplies from European countries that are denominated in euros. It expects the euro to increase in value over time and therefore desires to hedge its payables in euros. Memphis buys forward contracts on euros to lock in the price that it will pay for euros at a future point in time. Meanwhile, it will receive Mexican pesos in the future and wants to hedge these receivables. Memphis sells forward contracts on pesos to lock in the dollars that it will receive when it sells the pesos at a specified point in the future. ■

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The liquidity of the forward market varies among currencies. The forward market for euros is very liquid because many MNCs take forward positions to hedge their future payments in euros. In contrast, the forward markets for Latin American and Eastern European currencies are less liquid because there is less international trade with those countries and therefore MNCs take fewer forward positions. For some currencies, there is no forward market. Some quotations of exchange rates include forward rates for the most widely traded currencies. Other forward rates are not quoted in business newspapers but are quoted by the banks that offer forward contracts in various currencies.

Currency Futures Contracts. Futures contracts are somewhat similar to forward contracts except that they are sold on an exchange whereas forward contracts are offered by commercial banks. A currency futures contract speciﬁes a standard volume of a particular currency to be exchanged on a speciﬁc settlement date. Some MNCs involved in international trade use the currency futures markets to hedge their positions. Additional details on futures contracts, including other differences from forward contracts, are provided in Chapter 5.

Currency Options Contracts. Currency options contracts can be classiﬁed as calls or puts. A currency call option provides the right to buy a speciﬁc currency at a speciﬁc price (called the strike price or exercise price) within a speciﬁc period of time. It is used to hedge future payables. A currency put option provides the right to sell a speciﬁc currency at a speciﬁc price within a speciﬁc period of time. It is used to hedge future receivables. Currency call and put options can be purchased on an exchange. They offer more ﬂexibility than forward or futures contracts because they do not require any obligation. That is, the ﬁ rm can elect not to exercise the option. Currency options have become a popular means of hedging. The Coca-Cola Co. has replaced about 30 to 40 percent of its forward contracting with currency options. FMC, a U.S. manufacturer of chemicals and machinery, now hedges its foreign sales with currency options instead of forward contracts. While most MNCs commonly use forward contracts, many of them also use currency options. Additional details about currency options, including other differences from futures and forward contracts, are provided in Chapter 5.

International Money Market In most countries, local corporations commonly need to borrow short-term funds to support their operations. Country governments may also need to borrow short-term funds to ﬁ nance their budget deﬁcits. Individuals or local institutional investors in those countries provide funds through short-term deposits at commercial banks. In addition, corporations and governments may issue short-term securities that are purchased by local investors. Thus, a domestic money market in each country serves to transfer short-term funds denominated in the local currency from local surplus units (savers) to local deﬁcit units (borrowers). The growth in international business has caused corporations or governments in a particular country to need short-term funds denominated in a currency that is different from their home currency. First, they may need to borrow funds to pay for imports denominated in a foreign currency. Second, even if they need funds to support local operations, they may consider borrowing in a currency in which the interest rate is lower. This strategy is especially desirable if the ﬁ rms will have receivables denominated in that currency in the future. Third, they may consider borrowing in a cur-

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Part 1: The International Financial Environment

rency that will depreciate against their home currency, as they would be able to repay the loan at a more favorable exchange rate over time. Thus, the actual cost of borrowing would be less than the interest rate of that currency. Meanwhile, there are some corporations and institutional investors that have motives to invest in a foreign currency rather than their home currency. First, the interest rate that they would receive from investing in their home currency may be lower than what they could earn on short-term investments denominated in some other currencies. Second, they may consider investing in a currency that will appreciate against their home currency because they would be able to convert that currency into their home currency at a more favorable exchange rate at the end of the investment period. Thus, the actual return on their investment would be higher than the quoted interest rate on that foreign currency. The preferences of corporations and governments to borrow in foreign currencies and of investors to make short-term investments in foreign currencies resulted in the creation of the international money market.

Origins and Development The international money market includes large banks in countries around the world. Two other important components of the international money market are the European money market and the Asian money market.

European Money Market. The origins of the European money market can be traced to the Eurocurrency market that developed during the 1960s and 1970s. As MNCs expanded their operations during that period, international ﬁ nancial intermediation emerged to accommodate their needs. Because the U.S. dollar was widely used even by foreign countries as a medium for international trade, there was a consistent need for dollars in Europe and elsewhere. To conduct international trade with European countries, corporations in the United States deposited U.S. dollars in European banks. The banks were willing to accept the deposits because they could lend the dollars to corporate customers based in Europe. These dollar deposits in banks in Europe (and on other continents as well) came to be known as Eurodollars, and the market for Eurodollars came to be known as the Eurocurrency market. (“Eurodollars” and “Eurocurrency” should not be confused with the “euro,” which is the currency of many European countries today.) The growth of the Eurocurrency market was stimulated by regulatory changes in the United States. For example, when the United States limited foreign lending by U.S. banks in 1968, foreign subsidiaries of U.S.-based MNCs could obtain U.S. dollars from banks in Europe via the Eurocurrency market. Similarly, when ceilings were placed on the interest rates paid on dollar deposits in the United States, MNCs transferred their funds to European banks, which were not subject to the ceilings. The growing importance of the Organization of Petroleum Exporting Countries (OPEC) also contributed to the growth of the Eurocurrency market. Because OPEC generally requires payment for oil in dollars, the OPEC countries began to use the Eurocurrency market to deposit a portion of their oil revenues. These dollar-denominated deposits are sometimes known as petrodollars. Oil revenues deposited in banks have sometimes been lent to oil-importing countries that are short of cash. As these countries purchase more oil, funds are again transferred to the oil-exporting countries, which in turn create new deposits. This recycling process has been an important source of funds for some countries. Today, the term Eurocurrency market is not used as often as in the past because several other international ﬁ nancial markets have been developed. The European money market is still an important part of the network of international money markets, however.

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Asian Money Market. Like the European money market, the Asian money market originated as a market involving mostly dollar-denominated deposits. Hence, it was originally known as the Asian dollar market. The market emerged to accommodate the needs of businesses that were using the U.S. dollar (and some other foreign currencies) as a medium of exchange for international trade. These businesses could not rely on banks in Europe because of the distance and different time zones. Today, the Asian money market, as it is now called, is centered in Hong Kong and Singapore, where large banks accept deposits and make loans in various foreign currencies. The major sources of deposits in the Asian money market are MNCs with excess cash and government agencies. Manufacturers are major borrowers in this market. Another function is interbank lending and borrowing. Banks that have more qualiﬁed loan applicants than they can accommodate use the interbank market to obtain additional funds. Banks in the Asian money market commonly borrow from or lend to banks in the European market.

Money Market Interest Rates among Currencies The quoted money market interest rates for various currencies are shown for a recent point in time in Exhibit 3.3. Notice how the money market rates vary substantially among some currencies. This is due to differences in the interaction of the total supply of short-term funds available (bank deposits) in a speciﬁc country versus the total demand for short-term funds by borrowers in that country. If there is a large supply of savings relative to the demand for short-term funds, the interest rate for that country will be relatively low. Japan’s short-term interest rates are typically very low for this reason. Conversely, if there is a strong demand to borrow a currency, and a low supply of savings in that currency, the interest rate will be relatively high. Interest rates in developing countries are typically higher than rates in other countries.

Standardizing Global Bank Regulations Regulations contributed to the development of the international money market because they imposed restrictions on some local markets, thereby encouraging local investors and borrowers to circumvent the restrictions in local markets. Differences Exhibit 3.3

Comparison of International Money Market Interest Rates

7%

One-year Interest Rates

6% 5% 4% 3% 2% 1% 0% Japan

Germany

United States

United Kingdom

Brazil

Australia

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Part 1: The International Financial Environment

in regulations among countries allowed banks in some countries to have comparative advantages over banks in other countries. Over time, international banking regulations have become more standardized, which allows for more competitive global banking. Three of the more signiﬁcant regulatory events allowing for a more competitive global playing ﬁeld are (1) the Single European Act, (2) the Basel Accord, and (3) the Basel II Accord.

Single European Act. One of the most signiﬁcant events affecting international banking was the Single European Act, which was phased in by 1992 throughout the European Union (EU) countries. The following are some of the more relevant provisions of the Single European Act for the banking industry: • Capital can ﬂow freely throughout Europe. • Banks can offer a wide variety of lending, leasing, and securities activities in the EU. • Regulations regarding competition, mergers, and taxes are similar throughout the EU. • A bank established in any one of the EU countries has the right to expand into any or all of the other EU countries. As a result of this act, banks have expanded across European countries. Efﬁciency in the European banking markets has increased because banks can more easily cross countries without concern for country-speciﬁc regulations that prevailed in the past. Another key provision of the act is that banks entering Europe receive the same banking powers as other banks there. Similar provisions apply to non-U.S. banks that enter the United States.

Basel Accord. Before 1987, capital standards imposed on banks varied across countries, which allowed some banks to have a comparative global advantage over others. As an example, suppose that banks in the United States were required to maintain more capital than foreign banks. Foreign banks would grow more easily, as they would need a relatively small amount of capital to support an increase in assets. Despite their low capital, such banks were not necessarily perceived as too risky because the governments in those countries were likely to back banks that experienced ﬁ nancial problems. Therefore, some non-U.S. banks had globally competitive advantages over U.S. banks, without being subject to excessive risk. In December 1987, 12 major industrialized countries attempted to resolve the disparity by proposing uniform bank standards. In July 1988, in the Basel Accord, central bank governors of the 12 countries agreed on standardized guidelines. Under these guidelines, banks must maintain capital equal to at least 4 percent of their assets. For this purpose, banks’ assets are weighted by risk. This essentially results in a higher required capital ratio for riskier assets. Off–balance sheet items are also accounted for so that banks cannot circumvent capital requirements by focusing on services that are not explicitly shown as assets on a balance sheet. Basel II Accord. Banking regulators that form the so-called Basel Committee are completing a new accord (called Basel II) to correct some inconsistencies that still exist. For example, banks in some countries have required better collateral to back their loans. The Basel II Accord is attempting to account for such differences among banks. In addition, this accord will account for operational risk, which is deﬁ ned by the Basel Committee as the risk of losses resulting from inadequate or failed internal processes or systems. The Basel Committee wants to encourage banks to improve their techniques for controlling operational risk, which could reduce failures in the banking system. The Basel Committee also plans to require banks to provide more

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63

information to existing and prospective shareholders about their exposure to different types of risk.

International Credit Market Multinational corporations and domestic ﬁ rms sometimes obtain medium-term funds through term loans from local ﬁ nancial institutions or through the issuance of notes (medium-term debt obligations) in their local markets. However, MNCs also have access to medium-term funds through banks located in foreign markets. Loans of one year or longer extended by banks to MNCs or government agencies in Europe are commonly called Eurocredits or Eurocredit loans. These loans are provided in the socalled Eurocredit market. The loans can be denominated in dollars or many other currencies and commonly have a maturity of 5 years. Because banks accept short-term deposits and sometimes provide longer-term loans, their asset and liability maturities do not match. This can adversely affect a bank’s performance during periods of rising interest rates, since the bank may have locked in a rate on its longer-term loans while the rate it pays on short-term deposits is rising over time. To avoid this risk, banks commonly use ﬂoating rate loans. The loan rate ﬂoats in accordance with the movement of some market interest rate, such as the London Interbank Offer Rate (LIBOR), which is the rate commonly charged for loans between banks. For example, a Eurocredit loan may have a loan rate that adjusts every 6 months and is set at “LIBOR plus 3 percent.” The premium paid above LIBOR will depend on the credit risk of the borrower. The LIBOR varies among currencies because the market supply of and demand for funds vary among currencies. Because of the creation of the euro as the currency for several European countries, the key currency for interbank transactions in most of Europe is the euro. Thus, the term “eurobor” is widely used to reﬂect the interbank offer rate on euros. The international credit market is well developed in Asia and is developing in South America. Periodically, some regions are affected by an economic crisis, which increases the credit risk. Financial institutions tend to reduce their participation in those markets when credit risk increases. Thus, even though funding is widely available in many markets, the funds tend to move toward the markets where economic conditions are strong and credit risk is tolerable.

Syndicated Loans Sometimes a single bank is unwilling or unable to lend the amount needed by a particular corporation or government agency. In this case, a syndicate of banks may be organized. Each bank within the syndicate participates in the lending. A lead bank is responsible for negotiating terms with the borrower. Then the lead bank organizes a group of banks to underwrite the loans. The syndicate of banks is usually formed in about 6 weeks, or less if the borrower is well known, because then the credit evaluation can be conducted more quickly. Borrowers that receive a syndicated loan incur various fees besides the interest on the loan. Front-end management fees are paid to cover the costs of organizing the syndicate and underwriting the loan. In addition, a commitment fee of about .25 or .50 percent is charged annually on the unused portion of the available credit extended by the syndicate. Syndicated loans can be denominated in a variety of currencies. The interest rate depends on the currency denominating the loan, the maturity of the loan, and the creditworthiness of the borrower. Interest rates on syndicated loans are commonly adjustable according to movements in an interbank lending rate, and the adjustment may occur every 6 months or every year.

64

Part 1: The International Financial Environment

Syndicated loans not only reduce the default risk of a large loan to the degree of participation for each individual bank, but they can also add an extra incentive for the borrower to repay the loan. If a government defaults on a loan to a syndicate, word will quickly spread among banks, and the government will likely have difﬁculty obtaining future loans. Borrowers are therefore strongly encouraged to repay syndicated loans promptly. From the perspective of the banks, syndicated loans increase the probability of prompt repayment.

International Bond Market Although MNCs, like domestic ﬁ rms, can obtain long-term debt by issuing bonds in their local markets, MNCs can also access long-term funds in foreign markets. MNCs may choose to issue bonds in the international bond markets for three reasons. First, issuers recognize that they may be able to attract a stronger demand by issuing their bonds in a particular foreign country rather than in their home country. Some countries have a limited investor base, so MNCs in those countries seek ﬁ nancing elsewhere. Second, MNCs may prefer to ﬁ nance a speciﬁc foreign project in a particular currency and therefore may attempt to obtain funds where that currency is widely used. Third, ﬁ nancing in a foreign currency with a lower interest rate may enable an MNC to reduce its cost of ﬁ nancing, although it may be exposed to exchange rate risk (as explained in later chapters). Institutional investors such as commercial banks, mutual funds, insurance companies, and pension funds from many countries are major participants in the international bond market. Some institutional investors prefer to invest in international bond markets rather than their respective local markets when they can earn a higher return on bonds denominated in foreign currencies. International bonds are typically classiﬁed as either foreign bonds or Eurobonds. A foreign bond is issued by a borrower foreign to the country where the bond is placed. For example, a U.S. corporation may issue a bond denominated in Japanese yen, which is sold to investors in Japan. In some cases, a ﬁ rm may issue a variety of bonds in various countries. The currency denominating each type of bond is determined by the country where it is sold. These foreign bonds are sometimes speciﬁcally referred to as parallel bonds.

Eurobond Market Eurobonds are bonds that are sold in countries other than the country of the currency denominating the bonds. The emergence of the Eurobond market was partially the result of the Interest Equalization Tax (IET) imposed by the U.S. government in 1963 to discourage U.S. investors from investing in foreign securities. Thus, non-U.S. borrowers that historically had sold foreign securities to U.S. investors began to look elsewhere for funds. Further impetus to the market’s growth came in 1984 when the U.S. government abolished a withholding tax that it had formerly imposed on some non-U.S. investors and allowed U.S. corporations to issue bearer bonds directly to non-U.S. investors. Eurobonds have become very popular as a means of attracting funds, perhaps in part because they circumvent registration requirements. U.S.-based MNCs such as McDonald’s and Walt Disney commonly issue Eurobonds. Non-U.S. ﬁ rms such as Guinness, Nestlé, and Volkswagen also use the Eurobond market as a source of funds. In recent years, governments and corporations from emerging markets such as Croatia, Ukraine, Romania, and Hungary have frequently utilized the Eurobond market. New corporations that have been established in emerging markets rely on the Eurobond market to ﬁ nance their growth. They have to pay a risk premium of at least three percentage points annually above the U.S. Treasury bond rate on dollardenominated Eurobonds.

Chapter 3: International Financial Markets

65

Features of Eurobonds. Eurobonds have several distinctive features. They are usually issued in bearer form, which means that there are no records kept regarding ownership. Coupon payments are made yearly. Some Eurobonds carry a convertibility clause allowing them to be converted into a speciﬁed number of shares of common stock. An advantage to the issuer is that Eurobonds typically have few, if any, protective covenants. Furthermore, even short-maturity Eurobonds include call provisions. Some Eurobonds, called ﬂoating rate notes (FRNs), have a variable rate provision that adjusts the coupon rate over time according to prevailing market rates. Denominations. Eurobonds are commonly denominated in a number of currencies. Although the U.S. dollar is used most often, denominating 70 to 75 percent of Eurobonds, the euro will likely also be used to a signiﬁcant extent in the future. Recently, some ﬁ rms have issued debt denominated in Japanese yen to take advantage of Japan’s extremely low interest rates. Because interest rates for each currency and credit conditions change constantly, the popularity of particular currencies in the Eurobond market changes over time. Underwriting Process. Eurobonds are underwritten by a multinational syndicate of investment banks and simultaneously placed in many countries, providing a wide spectrum of fund sources to tap. The underwriting process takes place in a sequence of steps. The multinational managing syndicate sells the bonds to a large underwriting crew. In many cases, a special distribution to regional underwriters is allocated before the bonds ﬁ nally reach the bond purchasers. One problem with the distribution method is that the second- and third-stage underwriters do not always follow up on their promise to sell the bonds. The managing syndicate is therefore forced to redistribute the unsold bonds or to sell them directly, which creates “digestion” problems in the market and adds to the distribution cost. To avoid such problems, bonds are often distributed in higher volume to underwriters that have fulﬁ lled their commitments in the past at the expense of those that have not. This has helped the Eurobond market maintain its desirability as a bond placement center. Secondary Market. Eurobonds also have a secondary market. The market makers are in many cases the same underwriters who sell the primary issues. A technological advance called Euro-clear helps to inform all traders about outstanding issues for sale, thus allowing a more active secondary market. The intermediaries in the secondary market are based in 10 different countries, with those in the United Kingdom dominating the action. They can act not only as brokers but also as dealers that hold inventories of Eurobonds. Many of these intermediaries, such as Bank of America International, Smith Barney, and Citicorp International, are subsidiaries of U.S. corporations. Before the adoption of the euro in much of Europe, MNCs in European countries commonly preferred to issue bonds in their own local currency. The market for bonds in each currency was limited. Now, with the adoption of the euro, MNCs from many different countries can issue bonds denominated in euros, which allows for a much larger and more liquid market. MNCs have beneﬁted because they can more easily obtain debt by issuing bonds, as investors know that there will be adequate liquidity in the secondary market.

Development of Other Bond Markets Bond markets have developed in Asia and South America. Government agencies and MNCs in these regions use international bond markets to issue bonds when they believe they can reduce their ﬁ nancing costs. Investors in some countries use international bond markets because they expect their local currency to weaken in the future and

66

Part 1: The International Financial Environment

prefer to invest in bonds denominated in a strong foreign currency. The South American bond market has experienced limited growth because the interest rates in some countries there are usually high. MNCs and government agencies in those countries are unwilling to issue bonds when interest rates are so high, so they rely heavily on short-term ﬁ nancing.

International Stock Markets H T T P : // http://www.stockmarkets .com Information about stock markets around the world.

MNCs and domestic ﬁ rms commonly obtain long-term funding by issuing stock locally. Yet, MNCs can also attract funds from foreign investors by issuing stock in international markets. The stock offering may be more easily digested when it is issued in several markets. In addition, the issuance of stock in a foreign country can enhance the ﬁ rm’s image and name recognition there.

Issuance of Stock in Foreign Markets Some U.S. ﬁ rms issue stock in foreign markets to enhance their global image. The existence of various markets for new issues provides corporations in need of equity with a choice. This competition among various new-issues markets should increase the efﬁciency of new issues. The locations of an MNC’s operations can inﬂuence the decision about where to place its stock, as the MNC may desire a country where it is likely to generate enough future cash ﬂows to cover dividend payments. The stocks of some U.S.-based MNCs are widely traded on numerous stock exchanges around the world. This enables nonU.S. investors easy access to some U.S. stocks. MNCs need to have their stock listed on an exchange in any country where they issue shares. Investors in a foreign country are only willing to purchase stock if they can easily sell their holdings of the stock locally in the secondary market. The stock is denominated in the currency of the country where it is placed. For example, CocaCola stock issued to investors in Germany is denominated in euros. Investors in Germany can easily sell their shares of Coca-Cola stock locally in the German secondary market.

Impact of the Euro. The recent conversion of many European countries to a single currency (the euro) has resulted in more stock offerings in Europe by U.S.and European-based MNCs. In the past, an MNC needed a different currency in every country where it conducted business and therefore borrowed currencies from local banks in those countries. Now, it can use the euro to ﬁ nance its operations across several European countries and may be able to obtain all the ﬁ nancing it needs with one stock offering in which the stock is denominated in euros. The MNCs can then use a portion of the revenue (in euros) to pay dividends to shareholders who have purchased the stock.

Issuance of Foreign Stock in the United States Non-U.S. corporations that need large amounts of funds sometimes issue stock in the United States (these are called Yankee stock offerings) due to the liquidity of the newissues market there. In other words, a foreign corporation may be more likely to sell an entire issue of stock in the U.S. market, whereas in other, smaller markets, the entire issue may not necessarily sell. When a non-U.S. ﬁ rm issues stock in its own country, its shareholder base is quite limited, as a few large institutional investors may own most of the shares. By issuing stock in the United States, such a ﬁ rm diversiﬁes its shareholder base, which can reduce share price volatility caused when large investors sell shares.

Chapter 3: International Financial Markets

67

The U.S. investment banks commonly serve as underwriters of the stock targeted for the U.S. market and receive underwriting fees representing about 7 percent of the value of stock issued. Since many ﬁ nancial institutions in the United States purchase non-U.S. stocks as investments, non-U.S. ﬁ rms may be able to place an entire stock offering within the United States. Many of the recent stock offerings in the United States by non-U.S. ﬁ rms have resulted from privatization programs in Latin America and Europe. Thus, businesses that were previously government owned are being sold to U.S. shareholders. Given the large size of some of these businesses, the local stock markets are not large enough to digest the stock offerings. Consequently, U.S. investors are ﬁ nancing many privatized businesses based in foreign countries. Firms that issue stock in the United States typically are required to satisfy stringent disclosure rules on their ﬁ nancial condition. However, they are exempt from some of these rules when they qualify for a Securities and Exchange Commission guideline (called Rule 144a) through a direct placement of stock to institutional investors.

American Depository Receipts. Non-U.S. ﬁ rms also obtain equity ﬁ nancing by using American depository receipts (ADRs), which are certiﬁcates representing bundles of stock. The use of ADRs circumvents some disclosure requirements imposed on stock offerings in the United States, yet enables non-U.S. ﬁ rms to tap the U.S. market for funds. The ADR market grew after businesses were privatized in the early 1990s, as some of these businesses issued ADRs to obtain ﬁ nancing. Since ADR shares can be traded just like shares of a stock, the price of an ADR changes each day in response to demand and supply conditions. Over time, however, the value of an ADR should move in tandem with the value of the corresponding stock that is listed on the foreign stock exchange, after adjusting for exchange rate effects. The formula for calculating the price of an ADR is: PADR 5 PFS 3 S where PADR represents the price of the ADR, PFS represents the price of the foreign stock measured in foreign currency, and S is the spot rate of the foreign currency. A share of the ADR of the French firm Pari represents one share of this firm’s stock that is traded on a French stock exchange. The share price of Pari was 20 euros when the French market closed. As the U.S. stock market opens, the euro is worth $1.05, so the ADR price should be:

E X A M P L E

PADR 5 PFS 3 S 5 20 3 $1.05 5 $21

H T T P : // http://www.wall-street.com/ foreign.html Provides links to many stock markets.

■

If there is a discrepancy between the ADR price and the price of the foreign stock (after adjusting for the exchange rate), investors can use arbitrage to capitalize on the discrepancy between the prices of the two assets. The act of arbitrage should realign the prices. Assume no transaction costs. If PADR (PFS S), then ADR shares will flow back to France. They will be converted to shares of the French stock and will be traded in the French market. Investors can engage in arbitrage by buying the ADR shares in the United States, converting them to shares of the French stock, and then selling those shares on the French stock exchange where the stock is listed. The arbitrage will (1) reduce the supply of ADRs traded in the U.S. market, thereby putting upward pressure on the ADR price, and (2) increase the supply of the French shares traded in

E X X A M P L E

68

Part 1: The International Financial Environment the French market, thereby putting downward pressure on the stock price in France. The arbitrage will continue until the discrepancy in prices disappears. ■

The preceding example assumed a conversion rate of one ADR share per share of stock. Some ADRs are convertible into more than one share of the corresponding stock. Under these conditions, arbitrage will occur only if: PADR 5 Conv 3 PFS 3 S where Conv represents the number of shares of foreign stock that can be obtained for the ADR.

E X A M P L E

If the Pari ADR from the previous example is convertible into two shares of stock, the ADR price should be:

PADR 5 2 3 20 3 $1.05 5 $42 In this case, the ADR shares will be converted into shares of stock only if the ADR price is less than $42. ■

In reality, some transaction costs are associated with converting ADRs to foreign shares. Thus, arbitrage will occur only if the potential arbitrage proﬁt exceeds the transaction costs.

Listing of Stock by Non-U.S. Firms on U.S. Stock Exchanges Non-U.S. ﬁ rms that issue stock in the United States have their shares listed on the New York Stock Exchange, the American Stock Exchange, or the Nasdaq market. By listing their stock on a U.S. stock exchange, the shares placed in the United States can easily be traded in the secondary market. Effect of Sarbanes-Oxley Act on Foreign Stock Offerings In 2002, the Sarbanes-Oxley Act was passed in the United States. This act requires that firms whose stock is listed on U.S. stock exchanges provide more complete financial disclosure. The Sarbanes-Oxley Act is the result of financial scandals involving U.S.-based MNCs such as Enron and WorldCom that used misleading financial statements to hide their weak financial condition from investors. Investors overestimated the value of the stocks of these companies and lost most or all of their investment. The Sarbanes-Oxley Act was intended to ensure that financial reporting was more accurate and complete. The cost to firms for complying with the act was estimated to be more than $1 million per year for some firms. Consequently, many non-U.S. firms that issued new shares of stock decided to place their stock in the United Kingdom instead of in the United States so that they would not have to comply with the law. Furthermore, some U.S. firms that went public decided to place their stock in the United Kingdom so that they would not have to comply with the law. ■

GOVE ER RN NA AN NC CE E

H T T P : // http://ﬁnance.yahoo.com/? Access to various domestic and international ﬁnancial markets and ﬁnancial market news, as well as links to national ﬁnancial news servers.

Investing in Foreign Stock Markets Just as some MNCs issue stock outside their home country, many investors purchase stocks outside of the home country. First, they may expect that economic conditions will be very favorable in a particular country and invest in stocks of the ﬁ rms in that country. Second, investors may consider investing in stocks denominated in currencies that they expect will strengthen over time, since that would enhance the return on their investment. Third, some investors invest in stocks of other countries as a means of diversifying their portfolio. Thus, their investment is less sensitive to possi-

Chapter 3: International Financial Markets

69

Exhibit 3.4 Comparison of Global Stock Exchanges Number of Listed Domestic Companies

Market Capitalization (in millions of $)

Number of Listed Domestic Companies

789,563

269

3,678,262

3,220

Country

Market Capitalization (in millions of $)

Argentina

61,478

101

776,403

1,515

Austria

85,815

99

Jamaica

37,639

39

Belgium

768,377

170

Malaysia

180,346

1,020

Brazil

474,647

381

Mexico

239,128

151

1,177,518

3,597

Netherlands

622,284

234

Chile

136,446

245

93,873

248

China

780,763

1,387

Singapore

171,555

489

38,345

36

Spain

940,673

3,272

183,765

134

Sweden

376,781

256

1,194,517

660

Switzerland

825,849

282

Hong Kong

861,463

1,086

Thailand

123,539

468

India

553,074

4,763

U.K.

2,815,928

2,486

Ireland

114,085

53

U.S.

16,323,726

5,231

Israel

120,114

572

Australia

Canada

Czech Republic Finland Germany

Country Italy Japan

Poland

Source: World Development Indicators, World Bank.

ble adverse stock market conditions in their home country. More details about investing in international stock markets are provided in the appendix to this chapter.

H T T P : // http://www.worldbank.org/ data Information about the market capitalization, stock trading volume, and turnover for each stock market.

Comparison of Stock Markets. Exhibit 3.4 provides a summary of the major stock markets, but there are numerous other exchanges. Some foreign stock markets are much smaller than the U.S. markets because their ﬁ rms have relied more on debt ﬁ nancing than equity ﬁ nancing in the past. Recently, however, ﬁ rms outside the United States have been issuing stock more frequently, which has resulted in the growth of non-U.S. stock markets. The percentage of individual versus institutional ownership of shares varies across stock markets. Financial institutions and other ﬁ rms own a large proportion of the shares outside the United States, while individual investors own a relatively small proportion of shares. Large MNCs have begun to ﬂoat new stock issues simultaneously in various countries. Investment banks underwrite stocks through one or more syndicates across countries. The global distribution of stock can reach a much larger market, so greater quantities of stock can be issued at a given price. In 2000, the Amsterdam, Brussels, and Paris stock exchanges merged to create the Euronext market. Since then, the Lisbon stock exchange has joined as well. In 2007, the NYSE joined Euronext to create NYSE Euronext, the largest global exchange. It represents a major step in creating a global stock exchange and will likely lead to more consolidation of stock exchanges across countries in the future. Most of the largest ﬁ rms based in Europe have listed their stock on the Euronext market. This market is likely to grow over time as other stock exchanges may join it. A single

70

Part 1: The International Financial Environment

European stock market with similar guidelines for all stocks regardless of their home country would make it easier for those investors who prefer to do all of their trading in one market. In recent years, many new stock markets have been developed. These so-called emerging markets enable foreign ﬁ rms to raise large amounts of capital by issuing stock. These markets may enable U.S. ﬁ rms doing business in emerging markets to raise funds by issuing stock there and listing their stock on the local stock exchanges. Market characteristics such as the amount of trading relative to market capitalization and the applicable tax rates can vary substantially among emerging markets.

How Stock Market Characteristics Vary among Countries. The degree of trading activity in each stock market is inﬂuenced by legal and other characteristics of the country. Shareholders in some countries have more rights than in other countries. For example, shareholders have more voting power in some countries than others. They can have inﬂuence on a wider variety of management issues in some countries. Second, the legal protection of shareholders varies substantially among countries. Shareholders in some countries may have more power to effectively sue publicly traded ﬁ rms if their executives or directors commit ﬁ nancial fraud. In general, common law countries such as the United States, Canada, and the United Kingdom allow for more legal protection than civil law countries such as France or Italy. Third, the government enforcement of securities laws varies among countries. A country could have laws to protect shareholders but no enforcement of the laws, which means that shareholders are not protected. Fourth, some countries tend to have less corporate corruption than others. Shareholders in these countries are less susceptible to major losses due to agency problems whereby managers use shareholder money for their own beneﬁts. Fifth, the degree of ﬁ nancial information that must be provided by public companies varies among countries. The variation may be due to the accounting laws set by the government for public companies or reporting rules enforced by local stock exchanges. Shareholders are less susceptible to losses due to a lack of information if the public companies are required to be more transparent in their ﬁ nancial reporting. In general, stock markets that allow more voting rights for shareholders, more legal protection, more enforcement of the laws, less corruption, and more stringent accounting requirements attract more investors who are willing to invest in stocks. This allows for more conﬁdence in the stock market and greater pricing efﬁciency (since there is a large enough set of investors who monitor each ﬁ rm). In addition, companies are attracted to the stock market when there are many investors because they can easily raise funds in the market under these conditions. Conversely, if a stock market does not attract investors, it will not attract companies that need to raise funds. These companies will either need to rely on stock markets in other countries or credit markets (such as bank loans) to raise funds.

How Financial Markets Facilitate MNC Functions Exhibit 3.5 illustrates the foreign cash ﬂow movements of a typical MNC. These cash ﬂows can be classiﬁed into four corporate functions, all of which generally require use of the foreign exchange markets. The spot market, forward market, currency futures market, and currency options market are all classiﬁed as foreign exchange markets. The ﬁ rst function is foreign trade with business clients. Exports generate foreign cash inﬂows, while imports require cash outﬂows. A second function is direct foreign

Chapter 3: International Financial Markets Exhibit 3.5

71

Foreign Cash Flow Chart of an MNC

MNC Parent

Exporting and Importing

Foreign Exchange Transactions

Foreign Business Clients

Earnings Remittance and Financing

Exporting and Importing

Short-Term Investment and Financing

International Money Markets

Mediumand Long-Term Financing

International Credit Markets

Foreign Exchange Markets Long-Term Financing

International Stock Markets

Foreign Subsidiaries Short-Term Investment and Financing Medium- and Long-Term Financing Long-Term Financing

investment, or the acquisition of foreign real assets. This function requires cash outﬂows but generates future inﬂows through remitted earnings back to the MNC parent or the sale of these foreign assets. A third function is short-term investment or ﬁ nancing in foreign securities. A fourth function is longer-term ﬁ nancing in the international bond or stock markets. An MNC’s parent may use international money or bond markets to obtain funds at a lower cost than they can be obtained locally.

SUMMARY ■ The foreign exchange market allows currencies to be exchanged in order to facilitate international trade or ﬁ nancial transactions. Commercial banks serve as ﬁ nancial intermediaries in this market. They stand ready to exchange currencies for immediate delivery in the spot market. In addition, they are also willing to negotiate forward contracts with MNCs that wish to buy or sell currencies at a future point in time.

■ The international money markets are composed of several large banks that accept deposits and provide short-term loans in various currencies. This market is used primarily by governments and large corporations. The European market is a part of the international money market. ■ The international credit markets are composed of the same commercial banks that serve the international money market. These banks convert some of

72

Part 1: The International Financial Environment

the deposits received into loans (for medium-term periods) to governments and large corporations.

pension funds are the major purchasers of bonds in the international bond market.

■ The international bond markets facilitate international transfers of long-term credit, thereby enabling governments and large corporations to borrow funds from various countries. The international bond market is facilitated by multinational syndicates of investment banks that help to place the bonds. Institutional investors such as mutual funds, banks, and

■ International stock markets enable ﬁ rms to obtain equity ﬁ nancing in foreign countries. Thus, these markets have helped MNCs ﬁ nance their international expansion. Institutional investors such as pension funds and mutual funds are the major purchasers of newly issued stock.

POINT

COUNTER-POINT

Should Firms That Go Public Engage in International Offerings? Point Yes. When a U.S. ﬁ rm issues stock to the public for the ﬁ rst time in an initial public offering (IPO), it is naturally concerned about whether it can place all of its shares at a reasonable price. It will be able to issue its stock at a higher price by attracting more investors. It will increase its demand by spreading the stock across countries. The higher the price at which it can issue stock, the lower is its cost of using equity capital. It can also establish a global name by spreading stock across countries. Counter-Point No. If a U.S. ﬁ rm spreads its stock across different countries at the time of the IPO, there will be less publicly traded stock in the United

SELF

States. Thus, it will not have as much liquidity in the secondary market. Investors desire stocks that they can easily sell in the secondary market, which means that they require that the stocks have liquidity. To the extent that a ﬁ rm reduces its liquidity in the United States by spreading its stock across countries, it may not attract sufﬁcient U.S. demand for the stock. Thus, its efforts to create global name recognition may reduce its name recognition in the United States. Who Is Correct? Use the Internet to learn more about this issue. Which argument do you support? Offer your own opinion on this issue.

TEST

Answers are provided in Appendix A at the back of the text. 1. Stetson Bank quotes a bid rate of $.784 for the Australian dollar and an ask rate of $.80. What is the bid/ask percentage spread?

QUESTIONS

AND

1. Motives for Investing in Foreign Money Markets. Explain why an MNC may invest funds in a ﬁ nancial market outside its own country. 2. Motives for Providing Credit in Foreign Markets. Explain why some ﬁ nancial institutions prefer to

2. Fullerton Bank quotes an ask rate of $.190 for the Peruvian currency (new sol) and a bid rate of $.188. Determine the bid/ask percentage spread. 3. Brieﬂy explain how MNCs can make use of each international ﬁ nancial market described in this chapter.

A P P L I CAT I O N S provide credit in ﬁ nancial markets outside their own country. 3. Exchange Rate Effects on Investing. Explain how the appreciation of the Australian dollar against the U.S. dollar would affect the return to a U.S.

Chapter 3: International Financial Markets

ﬁ rm that invested in an Australian money market security. 4. Exchange Rate Effects on Borrowing. Explain how the appreciation of the Japanese yen against the U.S. dollar would affect the return to a U.S. ﬁ rm that borrowed Japanese yen and used the proceeds for a U.S. project. 5. Bank Services. List some of the important characteristics of bank foreign exchange services that MNCs should consider. 6. Bid/Ask Spread. Utah Bank’s bid price for Canadian dollars is $.7938 and its ask price is $.81. What is the bid/ask percentage spread? 7. Bid/Ask Spread. Compute the bid/ask percentage spread for Mexican peso retail transactions in which the ask rate is $.11 and the bid rate is $.10. 8. Forward Contract. The Wolfpack Corp. is a U.S. exporter that invoices its exports to the United Kingdom in British pounds. If it expects that the pound will appreciate against the dollar in the future, should it hedge its exports with a forward contract? Explain. 9. Euro. Explain the foreign exchange situation for countries that use the euro when they engage in international trade among themselves. 10. Indirect Exchange Rate. If the direct exchange rate of the euro is worth $1.25, what is the indirect rate of the euro? That is, what is the value of a dollar in euros? 11. Cross Exchange Rate. Assume Poland’s currency (the zloty) is worth $.17 and the Japanese yen is worth $.008. What is the cross rate of the zloty with respect to yen? That is, how many yen equal a zloty? 12. Syndicated Loans. Explain how syndicated loans are used in international markets. 13. Loan Rates. Explain the process used by banks in the Eurocredit market to determine the rate to charge on loans. 14. International Markets. What is the function of the international money markets? Brieﬂy describe the reasons for the development and growth of the European money market. Explain how the international money, credit, and bond markets differ from one another. 15. Evolution of Floating Rates. Brieﬂy describe the historical developments that led to ﬂoating exchange rates as of 1973. 16. International Diversiﬁcation. Explain how the Asian crisis would have affected the returns to a U.S. ﬁ rm investing in the Asian stock markets as a means of international diversiﬁcation. (See the chapter appendix.)

73

17. Eurocredit Loans. a. With regard to Eurocredit loans, who are the

borrowers? b. Why would a bank desire to participate in syndi-

cated Eurocredit loans? c. What is LIBOR, and how is it used in the Euro-

credit market? 18. Foreign Exchange. You just came back from Canada, where the Canadian dollar was worth $.70. You still have C$200 from your trip and could exchange them for dollars at the airport, but the airport foreign exchange desk will only buy them for $.60. Next week, you will be going to Mexico and will need pesos. The airport foreign exchange desk will sell you pesos for $.10 per peso. You met a tourist at the airport who is from Mexico and is on his way to Canada. He is willing to buy your C$200 for 1,300 pesos. Should you accept the offer or cash the Canadian dollars in at the airport? Explain. 19. Foreign Stock Markets. Explain why ﬁ rms may issue stock in foreign markets. Why might U.S. ﬁ rms issue more stock in Europe since the conversion to a single currency in 1999? 20. Financing with Stock. Chapman Co. is a privately owned MNC in the United States that plans to engage in an initial public offering (IPO) of stock, so that it can ﬁ nance its international expansion. At the present time, world stock market conditions are very weak but are expected to improve. The U.S. market tends to be weak in periods when the other stock markets around the world are weak. A ﬁ nancial manager of Chapman Co. recommends that it wait until the world stock markets recover before it issues stock. Another manager believes that Chapman Co. could issue its stock now even if the price would be low, since its stock price should rise later once world stock markets recover. Who is correct? Explain. Advanced Questions 21. Effects of September 11. Why do you think the terrorist attack on the United States was expected to cause a decline in U.S. interest rates? Given the expectations for a decline in U.S. interest rates and stock prices, how were capital ﬂows between the United States and other countries likely affected? 22. International Financial Markets. Recently, Wal-Mart established two retail outlets in the city of Shanzen, China, which has a population of 3.7 million. These outlets are massive and contain products purchased locally as well as imports. As Wal-Mart generates earnings beyond what it needs in Shanzen, it may remit those earnings back to the United States.

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try, even though the euro is the currency used in both countries.

Wal-Mart is likely to build additional outlets in Shanzen or in other Chinese cities in the future. a. Explain how the Wal-Mart outlets in China

would use the spot market in foreign exchange. b. Explain how Wal-Mart might utilize the interna-

tional money markets when it is establishing other Wal-Mart stores in Asia. c. Explain how Wal-Mart could use the interna-

tional bond market to ﬁ nance the establishment of new outlets in foreign markets. 23. Interest Rates. Why do interest rates vary among countries? Why are interest rates normally similar for those European countries that use the euro as their currency? Offer a reason why the government interest rate of one country could be slightly higher than the government interest rate of another coun-

BLADES,

INC.

24. Interpreting Exchange Rate Quotations. Today you notice the following exchange rate quotations: (a) $1 3.00 Argentine pesos and (b) 1 Argentine peso .50 Canadian dollars. You need to purchase 100,000 Canadian dollars with U.S. dollars. How many U.S. dollars will you need for your purchase? Discussion in the Boardroom This exercise can be found in Appendix E at the back of this textbook. Running Your Own MNC This exercise can be found on the Xtra! website at http://maduraxtra.swlearning.com.

CASE

Decisions to Use International Financial Markets As a ﬁ nancial analyst for Blades, Inc., you are reasonably satisﬁed with Blades’ current setup of exporting “Speedos” (roller blades) to Thailand. Due to the unique arrangement with Blades’ primary customer in Thailand, forecasting the revenue to be generated there is a relatively easy task. Speciﬁcally, your customer has agreed to purchase 180,000 pairs of Speedos annually, for a period of 3 years, at a price of THB4,594 (THB Thai baht) per pair. The current direct quotation of the dollar-baht exchange rate is $0.024. The cost of goods sold incurred in Thailand (due to imports of the rubber and plastic components from Thailand) runs at approximately THB2,871 per pair of Speedos, but Blades currently only imports materials sufﬁcient to manufacture about 72,000 pairs of Speedos. Blades’ primary reasons for using a Thai supplier are the high quality of the components and the low cost, which has been facilitated by a continuing depreciation of the Thai baht against the U.S. dollar. If the dollar cost of buying components becomes more expensive in Thailand than in the United States, Blades is contemplating providing its U.S. supplier with the additional business. Your plan is quite simple; Blades is currently using its Thai-denominated revenues to cover the cost of goods sold incurred there. During the last year, excess revenue was converted to U.S. dollars at the prevailing exchange rate. Although your cost of goods sold is not ﬁ xed contractually as the Thai revenues are, you expect them to remain relatively constant in the near future. Consequently, the baht-denominated cash in-

ﬂows are fairly predictable each year because the Thai customer has committed to the purchase of 180,000 pairs of Speedos at a ﬁ xed price. The excess dollar revenue resulting from the conversion of baht is used either to support the U.S. production of Speedos if needed or to invest in the United States. Speciﬁcally, the revenues are used to cover cost of goods sold in the U.S. manufacturing plant, located in Omaha, Nebraska. Ben Holt, Blades’ CFO, notices that Thailand’s interest rates are approximately 15 percent (versus 8 percent in the United States). You interpret the high interest rates in Thailand as an indication of the uncertainty resulting from Thailand’s unstable economy. Holt asks you to assess the feasibility of investing Blades’ excess funds from Thailand operations in Thailand at an interest rate of 15 percent. After you express your opposition to his plan, Holt asks you to detail the reasons in a detailed report. 1. One point of concern for you is that there is a tradeoff between the higher interest rates in Thailand and the delayed conversion of baht into dollars. Explain what this means. 2. If the net baht received from the Thailand operation are invested in Thailand, how will U.S. operations be affected? (Assume that Blades is currently paying 10 percent on dollars borrowed and needs more ﬁ nancing for its ﬁ rm.) 3. Construct a spreadsheet to compare the cash ﬂows resulting from two plans. Under the ﬁ rst plan, net baht-denominated cash ﬂows (received today) will

Chapter 3: International Financial Markets

be invested in Thailand at 15 percent for a one-year period, after which the baht will be converted to dollars. The expected spot rate for the baht in one year is about $.022 (Ben Holt’s plan). Under the second plan, net baht-denominated cash ﬂows are converted to dollars immediately and invested in the United States for one year at 8 percent. For this

SMALL

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75

question, assume that all baht-denominated cash ﬂows are due today. Does Holt’s plan seem superior in terms of dollar cash ﬂows available after one year? Compare the choice of investing the funds versus using the funds to provide needed ﬁ nancing to the ﬁ rm.

DILEMMA

Use of the Foreign Exchange Markets by the Sports Exports Company Each month, the Sports Exports Company (a U.S. ﬁ rm) receives an order for footballs from a British sporting goods distributor. The monthly payment for the footballs is denominated in British pounds, as requested by the British distributor. Jim Logan, owner of the Sports Exports Company, must convert the pounds received into dollars.

I N T E R N E T/ E XC E L The Bloomberg website provides quotations of various exchange rates and stock market indexes. Its website address is http://www.bloomberg.com. 1. Go to the section on currencies within the website. First, identify the direct exchange rates of foreign currencies from the U.S. perspective. Then, identify the indirect exchange rates. What is the direct exchange rate of the euro? What is the indirect exchange rate of the euro? What is the relationship between the direct and indirect exchange rates of the euro?

1. Explain how the Sports Exports Company could utilize the spot market to facilitate the exchange of currencies. Be speciﬁc. 2. Explain how the Sports Exports Company is exposed to exchange rate risk and how it could use the forward market to hedge this risk.

EXERCISES 2. Use this website to determine the cross exchange rate between the Japanese yen and the Australian dollar. That is, determine how many yen must be converted to an Australian dollar for Japanese importers that purchase Australian products today. How many Australian dollars are equal to a Japanese yen? What is the relationship between the exchange rate measured as number of yen per Australian dollar and the exchange rate measured as number of Australian dollars per yen?

APPENDIX 3 Investing in International Financial Markets

H T T P : // http://money.cnn.com Current national and international market data and analyses.

H T T P : // http://123world.com/ stockexchanges Summary of links to stock exchanges around the world.

The trading of ﬁ nancial assets (such as stocks or bonds) by investors in international ﬁ nancial markets has a major impact on MNCs. First, this type of trading can inﬂuence the level of interest rates in a speciﬁc country (and therefore the cost of debt to an MNC) because it affects the amount of funds available there. Second, it can affect the price of an MNC’s stock (and therefore the cost of equity to an MNC) because it inﬂuences the demand for the MNC’s stock. Third, it enables MNCs to sell securities in foreign markets. So, even though international investing in ﬁ nancial assets is not the most crucial activity of MNCs, international investing by individual and institutional investors can indirectly affect the actions and performance of an MNC. Consequently, an understanding of the motives and methods of international investing is necessary to anticipate how the international ﬂow of funds may change in the future and how that change may affect MNCs.

Background on International Stock Exchanges The international trading of stocks has grown over time but has been limited by three barriers: transaction costs, information costs, and exchange rate risk. In recent years, however, these barriers have been reduced as explained here.

Reduction in Transaction Costs Most countries tend to have their own stock exchanges, where the stocks of local publicly held companies are traded. In recent years, exchanges have been consolidated within a country, which has increased efﬁciency and reduced transaction costs. Some European stock exchanges now have extensive cross-listings so that investors in a given European country can easily purchase stocks of companies based in other European countries. In particular, because of its efﬁciency, the stock exchange of Switzerland may serve as a model that will be applied to many other stock exchanges around the world. The Swiss stock exchange is now fully computerized, so a trading ﬂoor is not needed. Orders by investors to buy or sell ﬂow to ﬁ nancial institutions that are certiﬁed members of the Swiss stock exchange. These institutions are not necessarily based in Switzerland. The details of the orders, such as the name of the stock, the number of shares to be bought or sold, and the price at which the investor is willing to buy or sell, are fed into a computer system. The system matches buyers and sellers and then sends information conﬁ rming the transaction to the ﬁ nancial institution, which informs the investor that the transaction is completed.

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http://www.sec.gov/investor/ pubs/ininvest.htm Information from the Securities and Exchange Commission about international investing.

When there are many more buy orders than sell orders for a given stock, the computer is unable to accommodate all orders. Some buyers will then increase the price they are willing to pay for the stock. Thus, the price adjusts in response to the demand (buy orders) for the stock and the supply (sell orders) of the stock for sale recorded by the computer system. Similar dynamics occur when a trading ﬂoor is used, but the computerized system has documented criteria by which it prioritizes the execution of orders; traders on a trading ﬂoor may execute some trades in ways that favor themselves at the expense of investors. In recent years, electronic communications networks (ECNs) have been created in many countries to match orders between buyers and sellers. Like the Swiss stock exchange, ECNs do not have a visible trading ﬂoor: the trades are executed by a computer network. Examples of popular ECNs include Archipelago, Instinet, and Tradebook. With an ECN, investors can place orders on their computers that are then executed by the computer system and conﬁ rmed through the Internet to the investor. Thus, all parts of the trading process from the placement of the order to the conﬁ rmation that the transaction has been executed are conducted by computer. The ease with which such orders can occur, regardless of the locations of the investor and the stock exchange, is sure to increase the volume of international stock transactions in the future.

Impact of Alliances. Several stock exchanges have created international alliances with the stock exchanges of other countries, thereby enabling ﬁ rms to more easily cross-list their shares among various stock markets. This gives investors easier and cheaper access to foreign stocks. The alliances also allow greater integration between markets. At some point in the future, there may be one global stock market in which any stock of any country can be easily purchased or sold by investors around the world. A single global stock market would allow U.S. investors to easily purchase any stock, regardless of where the corporation is based or the currency in which the stock is denominated. The international alliances are a ﬁ rst step toward a single global stock market. The costs of international stock transactions have already been substantially reduced as a result of some of the alliances.

Reduction in Information Costs The Internet provides investors with access to much information about foreign stocks, enabling them to make more informed decisions without having to purchase information about these stocks. Consequently, investors should be more comfortable assessing foreign stocks. Although differences in accounting rules still limit the degree to which ﬁ nancial data about foreign companies can be interpreted or compared to data about ﬁ rms in other countries, there is some momentum toward making accounting standards uniform across some countries.

Exchange Rate Risk When investing in a foreign stock that is denominated in a foreign currency, investors are subject to the possibility that the currency denominating the stock may depreciate against the investor’s currency over time. The potential for a major decline in the stock’s value simply because of a large degree of depreciation is more likely for emerging markets, such as Indonesia or Russia, where the local currency can change by 10 percent or more on a single day.

Measuring the Impact of Exchange Rates. The return to a U.S. investor from investing in a foreign stock is inﬂuenced by the return on the stock itself

APPENDIX 3

H T T P : //

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(R), which includes the dividend, and the percentage change in the exchange rate (e), as shown here: R$ 5 1 1 1 R 2 1 1 1 e 2 2 1

A year ago, Rob Grady invested in the stock of Vopka, a Russian company. Over the last year, the stock increased in value by 35 percent. Over this same period, however, the Russian ruble’s value declined by 30 percent. Rob sold the Vopka stock today. His return is:

E X A M P L E

R$ 5 1 1 1 R 2 1 1 1 e 2 2 1 5 1 1 1 .35 2 3 1 1 1 2.30 2 4 2 1 5 2.055 or 25.5% Even though the return on the stock was more pronounced than the exchange rate movement, Rob lost money on his investment. The reason is that the exchange rate movement of 30 percent wiped out not only 30 percent of his initial investment but also 30 percent of the stock’s return. ■

As the preceding example illustrates, investors should consider the potential inﬂuence of exchange rate movements on foreign stocks before investing in those stocks. Foreign investments are especially risky in developing countries, where exchange rates tend to be very volatile.

Reducing Exchange Rate Risk of Foreign Stocks. One method of reducing exchange rate risk is to take short positions in the foreign currencies denominating the foreign stocks. For example, a U.S. investor holding Mexican stocks who expects the stocks to be worth 10 million Mexican pesos one year from now could sell forward contracts (or futures contracts) representing 10 million pesos. The stocks could be liquidated at that time, and the pesos could be exchanged for dollars at a locked-in price. Although hedging the exchange rate risk of an international stock portfolio can be effective, it has three limitations. First, the number of foreign currency units to be converted to dollars at the end of the investment horizon is unknown. If the units received from liquidating the foreign stocks are more (less) than the amount hedged, the investor has a net long (short) position in that foreign currency, and the return will be unfavorably affected by its depreciation (appreciation). Nevertheless, though the hedge may not be perfect for this reason, investors normally should be able to hedge most of their exchange rate risk. A second limitation of hedging exchange rate risk is that the investors may decide to retain the foreign stocks beyond the initially planned investment horizon. Of course, they can create another forward contract after the initial forward contract is completed. If they ever decide to liquidate the foreign stocks prior to the forward delivery date, the hedge will be less effective. They could use the proceeds to invest in foreign money market securities denominated in that foreign currency in order to postpone conversion to dollars until the forward delivery date. But this prevents them from using the funds for other opportunities until that delivery date. A third limitation of hedging is that forward rates for currencies that are less widely traded may not exist or may exhibit a large discount.

International Stock Diversification A substantial amount of research has demonstrated that investors in stocks can beneﬁt by diversifying internationally. The stocks of most ﬁ rms are highly inﬂuenced by the

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sp 5 "w2Xs2X 1 w2Ys2Y 1 2wXwYsXsY 1 CORRXY 2 where wX is the proportion of funds invested in stock X, wY is the proportion of funds invested in stock Y, X is the standard deviation of returns for stock X, Y is the standard deviation of returns for stock Y, and CORR XY is the correlation coefﬁcient of returns between stock X and stock Y. From this equation, it should be clear that the standard deviation of returns (and therefore the risk) of a stock portfolio is positively related to the standard deviation of the individual stocks included within the portfolio and is also positively related to the correlations between individual stock returns. Much research has documented that stock returns are driven by their country market conditions. Therefore, individual stocks within a given country tend to be highly correlated. If country economies are segmented, their stock market returns should not be highly correlated, so the individual stocks of one country are not highly correlated with individual stocks of other countries. Thus, investors should be able to reduce the risk of their stock portfolio by investing in stocks among different countries.

Limitations of International Diversification H T T P : // http://ﬁnance.yahoo.com/ intlindices?u Charts showing recent stock market performance for each market. The prevailing stock index level is shown for each country, as well as the performance of each market during the previous day. For some markets, you can assess the performance over the last year by clicking on Chart next to the country’s name.

In general, correlations between stock indexes have been higher in recent years than they were several years ago. The general increase in correlations among stock market returns may have implications for MNCs that attempt to diversify internationally. To the extent that stock prices in each market reﬂect anticipated earnings, the increased correlations may suggest that more highly correlated anticipated earnings are expected among countries. Thus, the potential risk-reduction beneﬁts to an MNC that diversiﬁes its business may be limited. One reason for the increased correlations among stock market returns is increased integration of business between countries. Increased integration results in more intercountry trade ﬂows and capital ﬂows, which causes each country to have more inﬂuence on other countries. In particular, many European countries have become more integrated as regulations have been standardized throughout Europe to facilitate trade between countries. In addition, the adoption of the euro has removed exchange rate risk due to trade between participating countries. The conversion to the euro also allows portfolio managers in European countries to invest in stocks of other participating European countries without concern for exchange rate risk because these stocks are also denominated in euros. This facilitates a more regional approach for European investors, who are not restricted to stocks within their respective countries.

APPENDIX 3

countries where those ﬁ rms reside (although some ﬁ rms are more vulnerable to economic conditions than others). Since stock markets partially reﬂect the current and/or forecasted state of their countries’ economies, they do not move in tandem. Thus, particular stocks of the various markets are not expected to be highly correlated. This contrasts with a purely domestic portfolio in which most stocks often move in the same direction and by a somewhat similar magnitude. The risk of a stock portfolio can be measured by its volatility. Investors prefer a stock portfolio that has a lower degree of volatility because the future returns of a less volatile portfolio are subject to less uncertainty. The volatility of a single stock is commonly measured by its standard deviation of returns over a recent period. The volatility of a stock portfolio can also be measured by its standard deviation of returns over a recent period. The standard deviation of a stock portfolio is determined by the standard deviation of returns for each individual stock along with the correlations of returns between each pair of stocks in the portfolio, as shown below for a two-stock portfolio:

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Part 1: The International Financial Environment

Since some stock market correlations may become more pronounced during a crisis, international diversiﬁcation will not necessarily be as effective during a downturn as it is during more favorable conditions. An event that had an adverse effect on many markets was the Asian crisis, which is discussed next.

Market Movements during Crises. In the summer of 1997, Thailand experienced severe economic problems, which were followed by economic downturns in several other Asian countries. Investors revalued stocks downward because of weakened economic conditions, more political uncertainty, and a lack of conﬁdence that the problems would be resolved. The effects during the ﬁ rst year of the Asian crisis are summarized in Exhibit 3A.1. This crisis demonstrated how quickly stock prices could adjust to changing conditions and how adverse market conditions could spread across countries. Thus, diversiﬁcation across Asia did not effectively insulate investors during the Asian crisis. Diversiﬁcation across all continents would have been a more effective method of diversiﬁcation during the crisis. On August 27, 1998 (referred to as “Bloody Thursday”), Russian stock and currency values declined abruptly in response to severe ﬁ nancial problems in Russia, and most stock markets around the world experienced losses on that day. U.S. stocks declined by more than 4 percent on that day. The adverse effects extended beyond stocks that would be directly affected by ﬁ nancial problems in Russia as paranoia caused investors to sell stocks across all markets due to fears that all stocks might be overvalued. In response to the September 11, 2001, terrorist attacks on the United States, many stock markets experienced declines of more than 10 percent over the following week. Diversiﬁcation among markets was not very effective in reducing risk in this case.

Valuation of Foreign Stocks When investors consider investing in foreign stocks, they need methods for valuing those stocks. Exhibit 3A.1 How Stock Market Levels Changed during the Asian Crisis from a U.S. Perspective

South Korea –78%

Hong Kong –25%

India –51%

Philippines –67%

Thailand –86% Singapore –60% Indonesia –88%

Malaysia –75%

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81

One possibility is to use the dividend discount model with an adjustment to account for expected exchange rate movements. Foreign stocks pay dividends in the currency in which they are denominated. Thus, the cash ﬂow per period to U.S. investors is the dividend (denominated in the foreign currency) multiplied by the value of that foreign currency in dollars. The dividend can normally be forecasted with more accuracy than the value of the foreign currency. Because of exchange rate uncertainty, the value of the foreign stock from a U.S. investor’s perspective is subject to much uncertainty.

Price-Earnings Method An alternative method of valuing foreign stocks is to apply price-earnings ratios. The expected earnings per share of the foreign ﬁ rm are multiplied by the appropriate price-earnings ratio (based on the ﬁ rm’s risk and industry) to determine the appropriate price of the ﬁ rm’s stock. Although this method is easy to use, it is subject to some limitations when applied to valuing foreign stocks. The price-earnings ratio for a given industry may change continuously in some foreign markets, especially when the industry is composed of just a few ﬁ rms. Thus, it is difﬁ cult to determine the proper price-earnings ratio that should be applied to a speciﬁc foreign ﬁ rm. In addition, the price-earnings ratio for any particular industry may need to be adjusted for the ﬁ rm’s country, since reported earnings can be inﬂuenced by the ﬁ rm’s accounting guidelines and tax laws. Furthermore, even if U.S. investors are comfortable with their estimate of the proper price-earnings ratio, the value derived by this method is denominated in the local foreign currency (since the estimated earnings are denominated in that currency). Therefore, U.S. investors would still need to consider exchange rate effects. Even if the stock is undervalued in the foreign country, it may not necessarily generate a reasonable return for U.S. investors if the foreign currency depreciates against the dollar.

Other Methods Some investors adapt these methods when selecting foreign stocks. For example, they may ﬁ rst assess the macroeconomic conditions of all countries to screen out those countries that are expected to experience poor conditions in the future. Then, they use other methods such as the dividend discount model or the price-earnings method to value speciﬁc ﬁ rms within the countries that are appealing.

Why Perceptions of Stock Valuation Differ among Countries A stock that appears undervalued to investors in one country may seem overvalued to investors in another country. Some of the more common reasons why perceptions of a stock’s valuation may vary among investors in different countries are identiﬁed here.

Required Rate of Return. Some investors attempt to value a stock according to the present value of the future cash ﬂows that it will generate. The dividend discount model is one of many models that use this approach. The required rate of return that is used to discount the cash ﬂows can vary substantially among countries. It is based on the prevailing risk-free interest rate available to investors, plus a risk premium. For investors in the United States, the risk-free rate is typically below 10 percent. Thus, U.S. investors would apply a required rate of return of 12 to 15 percent in some cases. In contrast, investors in an emerging country that has a high riskfree rate would not be willing to accept such a low return. If they can earn a high return by investing in a risk-free asset, they would require a higher return than that to invest in risky assets such as stocks.

APPENDIX 3

Dividend Discount Model

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Part 1: The International Financial Environment

APPENDIX 3

Exchange Rate Risk. The exposure of investors to exchange rate risk from investing in foreign stocks is dependent on their home country. Investors in the United States who invest in a Brazilian stock are highly exposed to exchange rate risk, as the Brazilian currency (the real) has depreciated substantially against the dollar over time. Brazilian investors are not as exposed to exchange rate risk when investing in U.S. stocks, however, because there is less chance of a major depreciation in the dollar against the Brazilian real. In fact, Brazilian investors normally beneﬁt from investing in U.S. stocks because of the dollar’s appreciation against the Brazilian real. Indeed, the appreciation of the dollar is often necessary to generate an adequate return for Brazilian investors, given their high required return when investing in foreign stocks. Taxes. The tax effects of dividends and capital gains also vary among countries. The lower a country’s tax rates, the greater the proportion of the pretax cash ﬂows received that the investor can retain. Other things being equal, investors based in lowtax countries should value stocks higher. The valuation of stocks by investors within a given country changes in response to changes in tax laws. Before 2003, dividend income received by U.S. investors was taxed at ordinary income tax rates, which could be nearly 40 percent for some taxpayers. Consequently, many U.S. investors may have placed higher valuations on foreign stocks that paid low or no dividends (especially if the investors did not rely on the stocks to provide periodic income). Before 2003, the maximum tax on long-term capital gains was 20 percent, a rate that made foreign stocks that paid no dividends but had high potential for large capital gains very attractive. In 2003, however, the maximum tax rate on both dividends and long-term capital gains was set at 15 percent. Consequently, U.S. investors became more willing to consider foreign stocks that paid high dividends.

Methods Used to Invest Internationally H T T P : // http://www.investorhome .com/intl.htm Links to many useful websites on international investing.

For investors attempting international stock diversiﬁcation, ﬁve common approaches are available: • Direct purchases of foreign stocks • Investment in MNC stocks • American depository receipts (ADRs) • Exchange-traded funds (ETFs) • International mutual funds (IMFs) Each approach is discussed in turn.

Direct Purchases of Foreign Stocks Foreign stocks can be purchased on foreign stock exchanges. This requires the services of brokerage ﬁ rms that can execute the trades desired by investors at the foreign stock exchange of concern. However, this approach is inefﬁ cient because of market imperfections such as insufﬁcient information, transaction costs, and tax differentials among countries. An alternative method of investing directly in foreign stocks is to purchase stocks of foreign companies that are sold on the local stock exchange. In the United States, for example, Royal Dutch Shell (of the Netherlands), Sony (of Japan), and many other foreign stocks are sold on U.S. stock exchanges. Because the number of foreign stocks listed on any local stock exchange is typically quite limited, this method by itself may not be adequate to achieve the full beneﬁts of international diversiﬁcation.

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Investment in MNC Stocks The operations of an MNC represent international diversiﬁcation. Like an investor with a well-managed stock portfolio, an MNC can reduce risk (variability in net cash ﬂows) by diversifying sales not only among industries but also among countries. In this sense, the MNC as a single ﬁ rm can achieve stability similar to that of an internationally diversiﬁed stock portfolio. If MNC stocks behave like an international stock portfolio, then they should be sensitive to the stock markets of the various countries in which they operate. The sensitivity of returns of MNCs based in a particular country to speciﬁc international stock markets can be measured as: RMNC 5 a0 1 a1RL 1 b1RI,1 1 b2RI,2 1 c1 bnRI,n 1 u where R MNC is the average return on a portfolio of MNCs from the same country, a 0 is the intercept, R L is the return on the local stock market, RI,1 through RI,n are returns on foreign stock indices I1 through In, and u is an error term. The regression coefﬁcient a1 measures the sensitivity of MNC returns to their local stock market, while coefﬁcients b1 through bn measure the sensitivity of MNC returns to the various foreign stock markets. Studies have applied the time series regression model speciﬁed here and found that MNCs based in a particular country were typically affected only by their respective local stock markets and were not affected by other stock market movements. This suggests that the diversiﬁcation beneﬁts from investing in an MNC are limited.

American Depository Receipts H T T P : // http://www.adr.com Performance of ADRs.

Another approach is to purchase American depository receipts (ADRs), which are certiﬁcates representing ownership of foreign stocks. More than 1,000 ADRs are available in the United States, primarily traded on the over-the-counter (OTC) stock market. An investment in ADRs may be an adequate substitute for direct investment in foreign stocks.

Exchange-Traded Funds (ETFs) H T T P : // http://ﬁnance.yahoo.com/etf Performance of ETFs.

Although investors have closely monitored international stock indexes for years, they were typically unable to invest directly in these indexes. The index was simply a measure of performance for a set of stocks but was not traded. Exchange-traded funds (ETFs) represent indexes that reﬂect composites of stocks for particular countries; they were created to allow investors to invest directly in a stock index representing any one of several countries. ETFs are sometimes referred to as world equity benchmark shares (WEBS) or as iShares.

APPENDIX 3

Brokerage ﬁ rms have expanded the list of non-U.S. stocks that are available to U.S. investors. For example, Fidelity now executes stock transactions in many different countries for its U.S. investors. The transaction cost of investing directly in foreign stocks is higher than purchasing stocks on U.S. stock exchanges. One reason for the higher cost is that the foreign shares purchased by U.S. investors typically remain in the foreign country, and there is a cost of storing the stocks and processing records of ownership. However, some brokerage ﬁ rms such as Charles Schwab, Inc. have substantially reduced their fees for international stock transactions recently, but they may require a larger minimum transaction value (such as $5,000) to execute the transaction. The fees may even vary among foreign stocks at a given brokerage ﬁ rm. For example, the fees charged by E-Trade for executing foreign stock transactions vary with the home country of the stock.

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International Mutual Funds A ﬁ nal approach to consider is purchasing shares of international mutual funds (IMFs), which are portfolios of stocks from various countries. Several investment ﬁ rms, such as Fidelity, Vanguard, and Merrill Lynch, have constructed IMFs for their customers. Like domestic mutual funds, IMFs are popular due to (1) the low minimum investment necessary to participate in the funds, (2) the presumed expertise of the portfolio managers, and (3) the high degree of diversiﬁcation achieved by the portfolios’ inclusion of several stocks. Many investors believe an IMF can better reduce risk than a purely domestic mutual fund because the IMF includes foreign securities. An IMF represents a prepackaged portfolio, so investors who use it do not need to construct their own portfolios. Although some investors prefer to construct their own port folios, the existence of numerous IMFs on the market today allows investors to select the one that most closely resembles the type of portfolio they would have constructed on their own. Moreover, some investors feel more comfortable with a professional manager managing the international portfolio.

4: Exchange Rate Determination Financial managers of MNCs that conduct international business must continuously monitor exchange rates because their cash ﬂows are highly dependent on them. They need to understand what factors inﬂuence exchange rates so that they can anticipate how exchange rates may change in response to speciﬁc conditions. This chapter provides a foundation for understanding how exchange rates are determined.

The speciﬁc objectives of this chapter are to: ■ explain how exchange rate movements are measured, ■ explain how the equilibrium exchange rate is deter-

mined, and ■ examine factors that affect the equilibrium exchange

rate.

Measuring Exchange Rate Movements H T T P : // http://www.xe.com/ict/ Real-time exchange rate quotations.

Exchange rate movements affect an MNC’s value because they can affect the amount of cash inﬂows received from exporting or from a subsidiary and the amount of cash outﬂows needed to pay for imports. An exchange rate measures the value of one currency in units of another currency. As economic conditions change, exchange rates can change substantially. A decline in a currency’s value is often referred to as depreciation. When the British pound depreciates against the U.S. dollar, this means that the U.S. dollar is strengthening relative to the pound. The increase in a currency value is often referred to as appreciation. When a foreign currency’s spot rates at two speciﬁc points in time are compared, the spot rate at the more recent date is denoted as S and the spot rate at the earlier date is denoted as St1. The percentage change in the value of the foreign currency is computed as follows: Percent D in foreign currency value 5

H T T P : // http://www.federalreserve .gov/releases/ Current and historic exchange rates.

S 2 St21 St21

A positive percentage change indicates that the foreign currency has appreciated, while a negative percentage change indicates that it has depreciated. The values of some currencies have changed as much as 5 percent over a 24-hour period. On some days, most foreign currencies appreciate against the dollar, although by different degrees. On other days, most currencies depreciate against the dollar, but by different degrees. There are also days when some currencies appreciate while others depreciate against the dollar; the media describe this scenario by stating that “the dollar was mixed in trading.”

85

86

Part 1: The International Financial Environment Exchange rates for the Canadian dollar and the euro are shown in the second and fourth columns of Exhibit 4.1 for the months from January 1 to July 1. First, notice that the direction of the movement may persist for consecutive months in some cases or may not persist in other cases. The magnitude of the movement tends to vary every month, although the range of percentage movements over these months may be a reasonable indicator of the range of percentage movements in future months. A comparison of the movements in these two currencies suggests that they appear to move independently of each other. The movements in the euro are typically larger (regardless of direction) than movements in the Canadian dollar. This means that from a U.S. perspective, the euro is a more volatile currency. The standard deviation of the exchange rate movements for each currency (shown at the bottom of the table) verify this point. The standard deviation should be applied to percentage movements (not the values) when comparing volatility among currencies. ■

E X A M P L E

H T T P : // http://www.bis.org/ statistics/eer/index.htm Information on how each currency’s value has changed against a broad index of currencies.

Foreign exchange rate movements tend to be larger for longer time horizons. Thus, if yearly exchange rate data were assessed, the movements would be more volatile for each currency than what is shown here, but the euro’s movements would still be more volatile. If daily exchange rate movements were assessed, the movements would be less volatile for each currency than what is shown here, but the euro’s movements would still be more volatile. A review of daily exchange rate movements is important to an MNC that will need to obtain a foreign currency in a few days and wants to assess the possible degree of movement over that period. A review of annual exchange movements would be more appropriate for an MNC that conducts foreign trade every year and wants to assess the possible degree of movements on a yearly basis. Many MNCs review exchange rates based on short-term and long-term horizons because they expect to engage in international transactions in the near future and in the distant future.

Exchange Rate Equilibrium Although it is easy to measure the percentage change in the value of a currency, it is more difﬁcult to explain why the value changed or to forecast how it may change in the future. To achieve either of these objectives, the concept of an equilibrium exchange rate must be understood, as well as the factors that affect the equilibrium rate. Before considering why an exchange rate changes, realize that an exchange rate at a given point in time represents the price of a currency. Like any other products sold Exhibit 4.1

How Exchange Rate Movements and Volatility Are Measured Value of Canadian Dollar (C$)

Monthly % Change in C$

Value of Euro

Monthly % Change in Euro

Jan. 1

$.70

—

$1.18

—

Feb. 1

$.71

1.43%

$1.16

1.69%

March 1

$.703

0.99%

$1.15

0.86%

April 1

$.697

0.85%

$1.12

2.61%

May 1

$.692

0.72%

$1.11

0.89%

June 1

$.695

0.43%

$1.14

2.70%

July 1

$.686

1.29%

$1.17

2.63%

Standard deviation of monthly changes

1.04%

2.31%

Chapter 4: Exchange Rate Determination

87

in markets, the price of a currency is determined by the demand for that currency relative to supply. Thus, for each possible price of a British pound, there is a corresponding demand for pounds and a corresponding supply of pounds for sale. At any point in time, a currency should exhibit the price at which the demand for that currency is equal to supply, and this represents the equilibrium exchange rate. Of course, conditions can change over time, causing the supply or demand for a given currency to adjust, and thereby causing movement in the currency’s price. This topic is more thoroughly discussed in this section.

Demand for a Currency The British pound is used here to explain exchange rate equilibrium. The United Kingdom has not adopted the euro as its currency and continues to use the pound. Exhibit 4.2 shows a hypothetical number of pounds that would be demanded under various possibilities for the exchange rate. At any one point in time, there is only one exchange rate. The exhibit shows the quantity of pounds that would be demanded at various exchange rates at a speciﬁc point in time. The demand schedule is downward sloping because U.S. corporations will be encouraged to purchase more British goods when the pound is worth less, as it will take fewer dollars to obtain the desired amount of pounds.

Supply of a Currency for Sale Up to this point, only the U.S. demand for pounds has been considered, but the British demand for U.S. dollars must also be considered. This can be referred to as a British supply of pounds for sale, since pounds are supplied in the foreign exchange market in exchange for U.S. dollars. A supply schedule of pounds for sale in the foreign exchange market can be developed in a manner similar to the demand schedule for pounds. Exhibit 4.3 shows the quantity of pounds for sale (supplied to the foreign exchange market in exchange for dollars) corresponding to each possible exchange rate at a given point in time. Notice from the supply schedule in Exhibit 4.3 that there is a positive relationship between the value of the British pound and the quantity of British pounds for sale (supplied), which can be explained as follows. When the pound is valued high, British consumers Demand Schedule for British Pounds

Value of £

Exhibit 4.2

$1.60 $1.55 $1.50 D

Quantity of £

Part 1: The International Financial Environment Exhibit 4.3

Supply Schedule of British Pounds for Sale

S

Value of £

88

$1.60 $1.55 $1.50

Quantity of £

and ﬁrms are more likely to purchase U.S. goods. Thus, they supply a greater number of pounds to the market, to be exchanged for dollars. Conversely, when the pound is valued low, the supply of pounds for sale is smaller, reﬂecting less British desire to obtain U.S. goods.

Equilibrium The demand and supply schedules for British pounds are combined in Exhibit 4.4. At an exchange rate of $1.50, the quantity of pounds demanded would exceed the supply of pounds for sale. Consequently, the banks that provide foreign exchange services would experience a shortage of pounds at that exchange rate. At an exchange rate of $1.60, the quantity of pounds demanded would be less than the supply of pounds for sale. Therefore, banks providing foreign exchange services would experience a surplus of pounds at that exchange rate. According to Exhibit 4.4, the equilibrium exchange rate is $1.55 because this rate equates the quantity of pounds demanded with the supply of pounds for sale.

Impact of Liquidity. For all currencies, the equilibrium exchange rate is reached through transactions in the foreign exchange market, but for some currencies, the adjustment process is more volatile than for others. The liquidity of a currency affects the sensitivity of the exchange rate to speciﬁc transactions. If the currency’s spot market is liquid, its exchange rate will not be highly sensitive to a single large purchase or sale of the currency. Therefore, the change in the equilibrium exchange rate will be relatively small. With many willing buyers and sellers of the currency, transactions can be easily accommodated. Conversely, if the currency’s spot market is illiquid, its exchange rate may be highly sensitive to a single large purchase or sale transaction. There are not sufﬁcient buyers or sellers to accommodate a large transaction, which means that the price of the currency must change to rebalance the supply and demand for the currency. Consequently, illiquid currencies tend to exhibit more volatile exchange rate movements, as the equilibrium prices of their currencies adjust to even minor changes in supply and demand conditions.

Chapter 4: Exchange Rate Determination Exhibit 4.4

89

Equilibrium Exchange Rate Determination

S

Value of £

$1.60 $1.55 $1.50

D

Quantity of £

Factors That Inﬂuence Exchange Rates The equilibrium exchange rate will change over time as supply and demand schedules change. The factors that cause currency supply and demand schedules to change are discussed here by relating each factor’s inﬂuence to the demand and supply schedules graphically displayed in Exhibit 4.4. The following equation summarizes the factors that can inﬂuence a currency’s spot rate: e 5 f 1 DINF, DINT, DINC, DGC, DEXP 2 where e percentage change in the spot rate INF change in the differential between U.S. inﬂation and the foreign country’s inﬂation INT change in the differential between the U.S. interest rate and the foreign country’s interest rate INC change in the differential between the U.S. income level and the foreign country’s income level GC change in government controls EXP change in expectations of future exchange rates

Relative Inﬂation Rates Changes in relative inﬂation rates can affect international trade activity, which inﬂuences the demand for and supply of currencies and therefore inﬂuences exchange rates. Consider how the demand and supply schedules displayed in Exhibit 4.4 would be affected if U.S. inﬂation suddenly increased substantially while British inﬂation remained the same. (Assume that both British and U.S. ﬁrms sell goods that can serve as substitutes for each other.) The sudden jump in U.S. inﬂation should cause an increase in the U.S. demand for British goods and therefore also cause an increase in the U.S. demand for British pounds. In addition, the jump in U.S. inﬂation should reduce the British desire for U.S. goods and therefore reduce the supply of pounds for sale. These market reactions are illustrated

E X X A M P L E

90

Part 1: The International Financial Environment in Exhibit 4.5. At the previous equilibrium exchange rate of $1.55, there will be a shortage of pounds in the foreign exchange market. The increased U.S. demand for pounds and the reduced supply of pounds for sale place upward pressure on the value of the pound. According to Exhibit 4.5, the new equilibrium value is $1.57. ■

If British inﬂation increased (rather than U.S. inﬂation), the opposite forces would occur. Assume there is a sudden and substantial increase in British inﬂation while U.S. inﬂation is low. Based on this information, answer the following questions: (1) How is the demand schedule for pounds affected? (2) How is the supply schedule of pounds for sale affected? (3) Will the new equilibrium value of the pound increase, decrease, or remain unchanged? Based on the information given, the answers are (1) the demand schedule for pounds should shift inward, (2) the supply schedule of pounds for sale should shift outward, and (3) the new equilibrium value of the pound will decrease. Of course, the actual amount by which the pound’s value will decrease depends on the magnitude of the shifts. There is not enough information to determine their exact magnitude. ■

E X A M P L E

In reality, the actual demand and supply schedules, and therefore the true equilibrium exchange rate, will reﬂect several factors simultaneously. The point of the preceding example is to demonstrate how to logically work through the mechanics of the effect that higher inﬂation in a country can have on an exchange rate. Each factor is assessed one at a time to determine its separate inﬂuence on exchange rates, holding all other factors constant. Then, all factors can be tied together to fully explain why an exchange rate moves the way it does.

Relative Interest Rates Changes in relative interest rates affect investment in foreign securities, which inﬂuences the demand for and supply of currencies and therefore inﬂuences exchange rates. Assume that U.S. interest rates rise while British interest rates remain constant. In this case, U.S. investors will likely reduce their demand for pounds, since U.S. rates are now more attractive relative to British rates, and there is less desire for British bank deposits.

E X A M P L E

Impact of Rising U.S. Inﬂation on the Equilibrium Value of the British Pound

S2 S

Value of £

Exhibit 4.5

$1.60 $1.57 $1.55 $1.50 D2 D

Quantity of £

Chapter 4: Exchange Rate Determination

H T T P : // http://www.bloomberg.com Latest information from ﬁnancial markets around the world.

91

Because U.S. rates will now look more attractive to British investors with excess cash, the supply of pounds for sale by British investors should increase as they establish more bank deposits in the United States. Due to an inward shift in the demand for pounds and an outward shift in the supply of pounds for sale, the equilibrium exchange rate should decrease. This is graphically represented in Exhibit 4.6. If U.S. interest rates decreased relative to British interest rates, the opposite shifts would be expected. ■

In some cases, an exchange rate between two countries’ currencies can be affected by changes in a third country’s interest rate. When the Canadian interest rate increases, it can become more attractive to British investors than the U.S. rate. This encourages British investors to purchase fewer dollardenominated securities. Thus, the supply of pounds to be exchanged for dollars would be smaller than it would have been without the increase in Canadian interest rates, which places upward pressure on the value of the pound against the U.S. dollar. ■

E X X A M P L E

In the 1999–2000 period, European interest rates were relatively low compared to U.S. interest rates. This interest rate differential encouraged European investors to invest money in dollar-denominated debt securities. This activity resulted in a large supply of euros in the foreign exchange market and put downward pressure on the euro. In the 2002–2003 period, U.S. interest rates were lower than European interest rates. Consequently, there was a large U.S. demand for euros to capitalize on the higher interest rates, which placed upward pressure on the euro.

Real Interest Rates. Although a relatively high interest rate may attract foreign inﬂows (to invest in securities offering high yields), the relatively high interest rate may reﬂect expectations of relatively high inﬂation. Because high inﬂation can place downward pressure on the local currency, some foreign investors may be discouraged from investing in securities denominated in that currency. For this reason, it is helpful to consider the real interest rate, which adjusts the nominal interest rate for inﬂation: Real interest rate 艑 Nominal interest rate Inflation rate This relationship is sometimes called the Fisher effect. Exhibit 4.6

Impact of Rising U.S. Interest Rates on the Equilibrium Value of the British Pound

S S2 $1.60 Value of £

H T T P : // http://research.stlouisfed .org/fred2 Numerous economic and ﬁnancial time series, e.g., on balance-of-payment statistics and interest rates.

$1.55 $1.50

D D2 Quantity of £

92

Part 1: The International Financial Environment

The real interest rate is commonly compared among countries to assess exchange rate movements because it combines nominal interest rates and inﬂation, both of which inﬂuence exchange rates. Other things held constant, there should be a high correlation between the real interest rate differential and the dollar’s value.

Relative Income Levels A third factor affecting exchange rates is relative income levels. Because income can affect the amount of imports demanded, it can affect exchange rates. Assume that the U.S. income level rises substantially while the British income level remains unchanged. Consider the impact of this scenario on (1) the demand schedule for pounds, (2) the supply schedule of pounds for sale, and (3) the equilibrium exchange rate. First, the demand schedule for pounds will shift outward, reﬂecting the increase in U.S. income and therefore increased demand for British goods. Second, the supply schedule of pounds for sale is not expected to change. Therefore, the equilibrium exchange rate of the pound is expected to rise, as shown in Exhibit 4.7. ■

E X A M P L E

Changing income levels can also affect exchange rates indirectly through effects on interest rates. When this effect is considered, the impact may differ from the theory presented here, as will be explained shortly.

Government Controls A fourth factor affecting exchange rates is government controls. The governments of foreign countries can inﬂuence the equilibrium exchange rate in many ways, including (1) imposing foreign exchange barriers, (2) imposing foreign trade barriers, (3) intervening (buying and selling currencies) in the foreign exchange markets, and (4) affecting macro variables such as inﬂation, interest rates, and income levels. Chapter 6 covers these activities in detail.

Impact of Rising U.S. Income Levels on the Equilibrium Value of the British Pound

S $1.60 Value of £

Exhibit 4.7

$1.55 $1.50 D2 D

Quantity of £

Chapter 4: Exchange Rate Determination

93

Recall the example in which U.S. interest rates rose relative to British interest rates. The expected reaction was an increase in the British supply of pounds for sale to obtain more U.S. dollars (in order to capitalize on high U.S. money market yields). Yet, if the British government placed a heavy tax on interest income earned from foreign investments, this could discourage the exchange of pounds for dollars. ■

E X A M P L E

Expectations A ﬁfth factor affecting exchange rates is market expectations of future exchange rates. Like other ﬁnancial markets, foreign exchange markets react to any news that may have a future effect. News of a potential surge in U.S. inﬂation may cause currency traders to sell dollars, anticipating a future decline in the dollar’s value. This response places immediate downward pressure on the dollar. Many institutional investors (such as commercial banks and insurance companies) take currency positions based on anticipated interest rate movements in various countries. Investors may temporarily invest funds in Canada if they expect Canadian interest rates to increase. Such a rise may cause further capital ﬂows into Canada, which could place upward pressure on the Canadian dollar’s value. By taking a position based on expectations, investors can fully beneﬁt from the rise in the Canadian dollar’s value because they will have purchased Canadian dollars before the change occurred. Although the investors face an obvious risk here that their expectations may be wrong, the point is that expectations can inﬂuence exchange rates because they commonly motivate institutional investors to take foreign currency positions. ■

E X A M P L E

Impact of Signals on Currency Speculation. Day-to-day specH T T P : // http://www.ny.frb.org Links to information on economic conditions that affect foreign exchange rates and potential speculation in the foreign exchange market.

ulation on future exchange rate movements is commonly driven by signals of future interest rate movements, but it can also be driven by other factors. Signals of the future economic conditions that affect exchange rates can change quickly, so the speculative positions in currencies may adjust quickly, causing unclear patterns in exchange rates. It is not unusual for the dollar to strengthen substantially on a given day, only to weaken substantially on the next day. This can occur when speculators overreact to news on one day (causing the dollar to be overvalued), which results in a correction on the next day. Overreactions occur because speculators are commonly taking positions based on signals of future actions (rather than the conﬁrmation of actions), and these signals may be misleading. When speculators speculate on currencies in emerging markets, they can have a substantial impact on exchange rates. Those markets have a smaller amount of foreign exchange trading for other purposes (such as international trade) and therefore are less liquid than the larger markets. The abrupt decline in the Russian ruble on some days during 1998 was partially attributed to speculative trading (although the decline might have occurred anyway over time). The decline in the ruble created a lack of conﬁdence in other emerging markets as well and caused speculators to sell off other emerging market currencies, such as those of Poland and Venezuela. The market for the ruble is not very active, so a sudden shift in positions by speculators can have a substantial impact. ■

E X A M P L E

Interaction of Factors Transactions within the foreign exchange markets facilitate either trade or ﬁnancial ﬂows. Trade-related foreign exchange transactions are generally less responsive to

94

Part 1: The International Financial Environment

news. Financial ﬂow transactions are very responsive to news, however, because decisions to hold securities denominated in a particular currency are often dependent on anticipated changes in currency values. Sometimes trade-related factors and ﬁnancial factors interact and simultaneously affect exchange rate movements. An increase in income levels sometimes causes expectations of higher interest rates. So, even though a higher income level can result in more imports, it may also indirectly attract more ﬁnancial inﬂows (assuming interest rates increase). Because the favorable ﬁnancial ﬂows may overwhelm the unfavorable trade ﬂows, an increase in income levels is frequently expected to strengthen the local currency. ■

E E X X A A M M P P L L E E

Exhibit 4.8 separates payment ﬂows between countries into trade-related and ﬁnance-related ﬂows and summarizes the factors that affect these ﬂows. Over a particular period, some factors may place upward pressure on the value of a foreign currency while other factors place downward pressure on the currency’s value. Assume the simultaneous existence of (1) a sudden increase in U.S. inﬂation and (2) a sudden increase in U.S. interest rates. If the British economy is relatively unchanged, the increase in U.S. inﬂation will place upward pressure on the pound’s value while the increase in U.S. interest rates places downward pressure on the pound’s value. ■

E E X X A A M M P P L L E E

The sensitivity of an exchange rate to these factors is dependent on the volume of international transactions between the two countries. If the two countries engage in a large volume of international trade but a very small volume of international capital ﬂows, the relative inﬂation rates will likely be more inﬂuential. If the two countries engage in a large volume of capital ﬂows, however, interest rate ﬂuctuations may be more inﬂuential.

E E X X A A M M P P L L E E

Assume that Morgan Co., a U.S.-based MNC, commonly purchases supplies from Venezuela and Japan and therefore desires to forecast the direction of the Venezuelan

Exhibit 4.8 Summary of How Factors Can Affect Exchange Rates

Trade-Related Factors Inﬂation Differential

U.S. Demand for Foreign Goods

U.S. Demand for the Foreign Currency

Foreign Demand for U.S. Goods

Supply of the Foreign Currency for Sale

U.S. Demand for Foreign Securities

U.S. Demand for the Foreign Currency

Foreign Demand for U.S. Securities

Supply of the Foreign Currency for Sale

Income Differential Government Trade Restrictions

Financial Factors Interest Rate Differential Capital Flow Restrictions

Exchange Rate between the Foreign Currency and the Dollar

Chapter 4: Exchange Rate Determination

95

bolivar and the Japanese yen. Morgan’s ﬁnancial analysts have developed the following oneyear projections for economic conditions:

Factor

United States

Venezuela

Japan

Change in interest rates

1%

2%

4%

Change in inﬂation

2%

3%

6%

Assume that the United States and Venezuela conduct a large volume of international trade but engage in minimal capital ﬂow transactions. Also assume that the United States and Japan conduct very little international trade but frequently engage in capital ﬂow transactions. What should Morgan expect regarding the future value of the Venezuelan bolivar and the Japanese yen? The bolivar should be inﬂuenced most by trade-related factors because of Venezuela’s assumed heavy trade with the United States. The expected inﬂationary changes should place upward pressure on the value of the bolivar. Interest rates are expected to have little direct impact on the bolivar because of the assumed infrequent capital ﬂow transactions between the United States and Venezuela. The Japanese yen should be most inﬂuenced by interest rates because of Japan’s assumed heavy capital ﬂow transactions with the United States. The expected interest rate changes should place downward pressure on the yen. The inﬂationary changes are expected to have little direct impact on the yen because of the assumed infrequent trade between the two countries. ■

Capital ﬂows have become larger over time and can easily overwhelm trade ﬂows. For this reason, the relationship between the factors (such as inﬂation and income) that affect trade and exchange rates is not always as strong as one might expect. An understanding of exchange rate equilibrium does not guarantee accurate forecasts of future exchange rates because that will depend in part on how the factors that affect exchange rates will change in the future. Even if analysts fully realize how factors inﬂuence exchange rates, they may not be able to predict how those factors will change.

Speculating on Anticipated Exchange Rates Many commercial banks attempt to capitalize on their forecasts of anticipated exchange rate movements in the foreign exchange market, as illustrated in this example. • Chicago Bank expects the exchange rate of the New Zealand dollar (NZ$) to appreciate from its present level of $.50 to $.52 in 30 days. • Chicago Bank is able to borrow $20 million on a short-term basis from other banks. • Present short-term interest rates (annualized) in the interbank market are as follows:

Currency

Lending Rate

Borrowing Rate

U.S. dollars

6.72%

7.20%

New Zealand dollars (NZ$)

6.48%

6.96%

96

Part 1: The International Financial Environment

Because brokers sometimes serve as intermediaries between banks, the lending rate differs from the borrowing rate. Given this information, Chicago Bank could 1. Borrow $20 million. 2. Convert the $20 million to NZ$40 million (computed as $20,000,000/$.50). 3. Lend the New Zealand dollars at 6.48 percent annualized, which represents a .54 percent return over the 30-day period [computed as 6.48% (30/360)]. After 30 days, the bank will receive NZ$40,216,000 [computed as NZ$40,000,000 (1 .0054)]. 4. Use the proceeds from the New Zealand dollar loan repayment (on day 30) to repay the U.S. dollars borrowed. The annual interest on the U.S. dollars borrowed is 7.2 percent, or .6 percent over the 30-day period [computed as 7.2% (30/360)]. The total U.S. dollar amount necessary to repay the U.S. dollar loan is therefore $20,120,000 [computed as $20,000,000 (1 .006)]. Assuming that the exchange rate on day 30 is $.52 per New Zealand dollar as anticipated, the number of New Zealand dollars necessary to repay the U.S. dollar loan is NZ$38,692,308 (computed as $20,120,000/$.52 per New Zealand dollar). Given that the bank accumulated NZ$40,216,000 from lending New Zealand dollars, it would earn a speculative proﬁt of NZ$1,523,692, which is the equivalent of $792,320 (given a spot rate of $.52 per New Zealand dollar on day 30). The bank would earn this speculative proﬁt without using any funds from deposit accounts because the funds would have been borrowed through the interbank market. If, instead, Chicago Bank expects that the New Zealand dollar will depreciate, it can attempt to make a speculative proﬁt by taking positions opposite to those just described. To illustrate, assume that the bank expects an exchange rate of $.48 for the New Zealand dollar on day 30. It can borrow New Zealand dollars, convert them to U.S. dollars, and lend the U.S. dollars out. On day 30, it will close out these positions. Using the rates quoted in the previous example, and assuming the bank can borrow NZ$40 million, the bank takes the following steps: 1. Borrow NZ$40 million. 2. Convert the NZ$40 million to $20 million (computed as NZ$40,000,000 $.50). 3. Lend the U.S. dollars at 6.72 percent, which represents a .56 percent return over the 30-day period. After 30 days, the bank will receive $20,112,000 [computed as $20,000,000 (1 .0056)].

H T T P : // http://www.forex.com Individuals can open a foreign exchange trading account for a minimum of only $250. http://www.fxcm.com Facilitates the trading of foreign currencies. http://www.hedgestreet.com Facilitates the trading of foreign currencies.

4. Use the proceeds of the U.S. dollar loan repayment (on day 30) to repay the New Zealand dollars borrowed. The annual interest on the New Zealand dollars borrowed is 6.96 percent, or .58 percent over the 30-day period [computed as 6.969% (30/360)]. The total New Zealand dollar amount necessary to repay the loan is therefore NZ$40,232,000 [computed as NZ$40,000,000 (1 .0058)]. Assuming that the exchange rate on day 30 is $.48 per New Zealand dollar as anticipated, the number of U.S. dollars necessary to repay the NZ$ loan is $19,311,360 (computed as NZ$40,232,000 $.48 per New Zealand dollar). Given that the bank accumulated $20,112,000 from its U.S. dollar loan, it would earn a speculative proﬁt of $800,640 without using any of its own money (computed as $20,112,000 $19,311,360). Most money center banks continue to take some speculative positions in foreign currencies. In fact, some banks’ currency trading proﬁts have exceeded $100 million per quarter lately.

Chapter 4: Exchange Rate Determination

97

The potential returns from foreign currency speculation are high for banks that have large borrowing capacity. Nevertheless, foreign exchange rates are very volatile, and a poor forecast could result in a large loss. One of the best-known bank failures, Franklin National Bank in 1974, was primarily attributed to massive speculative losses from foreign currency positions.

SUMMARY ■ Exchange rate movements are commonly measured by the percentage change in their values over a speciﬁed period, such as a month or a year. MNCs closely monitor exchange rate movements over the period in which they have cash ﬂows denominated in the foreign currencies of concern. ■ The equilibrium exchange rate between two currencies at any point in time is based on the demand and supply conditions. Changes in the demand for a currency or the supply of a currency for sale will affect the equilibrium exchange rate. ■ The key economic factors that can inﬂuence exchange rate movements through their effects on demand and supply conditions are relative inﬂation rates, interest rates, and income levels, as well as government controls. As these factors cause a change in international trade or ﬁnancial ﬂows, they affect the demand for a currency or the supply of currency for sale and therefore affect the equilibrium exchange rate.

POINT

■ The two factors that are most closely monitored by foreign exchange market participants are relative inﬂation and interest rates: If a foreign country experiences high inﬂation (relative to the United States), its exports to the United States should decrease (U.S. demand for its currency decreases), its imports should increase (supply of its currency to be exchanged for dollars increases), and there is downward pressure on its currency’s equilibrium value. If a foreign country experiences an increase in interest rates (relative to U.S. interest rates), the inﬂow of U.S. funds to purchase its securities should increase (U.S. demand for its currency increases), the outﬂow of its funds to purchase U.S. securities should decrease (supply of its currency to be exchanged for U.S. dollars decreases), and there is upward pressure on its currency’s equilibrium value.

■ All relevant factors must be considered simultaneously to assess the likely movement in a currency’s value.

COUNTER-POINT

How Can Persistently Weak Currencies Be Stabilized? Point The currencies of some Latin American countries depreciate against the U.S. dollar on a consistent basis. The governments of these countries need to attract more capital ﬂows by raising interest rates and making their currencies more attractive. They also need to insure bank deposits so that foreign investors who invest in large bank deposits do not need to worry about default risk. In addition, they could impose capital restrictions on local investors to prevent capital outﬂows.

States instead. Thus, these countries could relieve the downward pressure on their local currencies by reducing inﬂation. To reduce inﬂation, a country may have to reduce economic growth temporarily. These countries should not raise their interest rates in order to attract foreign investment, because they will still not attract funds if investors fear that there will be large capital outﬂows upon the ﬁrst threat of continued depreciation.

Counter-Point Some Latin American countries have had high inﬂation, which encourages local ﬁrms and consumers to purchase products from the United

Who Is Correct? Use the Internet to learn more about this issue. Which argument do you support? Offer your own opinion on this issue.

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Part 1: The International Financial Environment

SELF

TEST

Answers are provided in Appendix A at the back of the text. 1. Brieﬂy describe how various economic factors can affect the equilibrium exchange rate of the Japanese yen’s value with respect to that of the dollar. 2. A recent shift in the interest rate differential between the United States and Country A had a large effect on the value of Currency A. However, the same shift in the interest rate differential between the United States and Country B had no effect on

QUESTIONS

AND

the value of Currency B. Explain why the effects may vary. 3. Smart Banking Corp. can borrow $5 million at 6 percent annualized. It can use the proceeds to invest in Canadian dollars at 9 percent annualized over a six-day period. The Canadian dollar is worth $.95 and is expected to be worth $.94 in six days. Based on this information, should Smart Banking Corp. borrow U.S. dollars and invest in Canadian dollars? What would be the gain or loss in U.S. dollars?

A P P L I CAT I O N S

1. Percentage Depreciation. Assume the spot rate of the British pound is $1.73. The expected spot rate one year from now is assumed to be $1.66. What percentage depreciation does this reﬂect? 2. Inﬂation Effects on Exchange Rates. Assume that the U.S. inﬂation rate becomes high relative to Canadian inﬂation. Other things being equal, how should this affect the (a) U.S. demand for Canadian dollars, (b) supply of Canadian dollars for sale, and (c) equilibrium value of the Canadian dollar? 3. Interest Rate Effects on Exchange Rates. Assume U.S. interest rates fall relative to British interest rates. Other things being equal, how should this affect the (a) U.S. demand for British pounds, (b) supply of pounds for sale, and (c) equilibrium value of the pound? 4. Income Effects on Exchange Rates. Assume that the U.S. income level rises at a much higher rate than does the Canadian income level. Other things being equal, how should this affect the (a) U.S. demand for Canadian dollars, (b) supply of Canadian dollars for sale, and (c) equilibrium value of the Canadian dollar? 5. Trade Restriction Effects on Exchange Rates. Assume that the Japanese government relaxes its controls on imports by Japanese companies. Other things being equal, how should this affect the (a) U.S. demand for Japanese yen, (b) supply of yen for sale, and (c) equilibrium value of the yen? 6. Effects of Real Interest Rates. What is the expected relationship between the relative real interest rates of two countries and the exchange rate of their currencies?

7. Speculative Effects on Exchange Rates. Explain why a public forecast by a respected economist about future interest rates could affect the value of the dollar today. Why do some forecasts by wellrespected economists have no impact on today’s value of the dollar? 8. Factors Affecting Exchange Rates. What factors affect the future movements in the value of the euro against the dollar? 9. Interaction of Exchange Rates. Assume that there are substantial capital ﬂows among Canada, the United States, and Japan. If interest rates in Canada decline to a level below the U.S. interest rate, and inﬂationary expectations remain unchanged, how could this affect the value of the Canadian dollar against the U.S. dollar? How might this decline in Canada’s interest rates possibly affect the value of the Canadian dollar against the Japanese yen? 10. Trade Deﬁcit Effects on Exchange Rates. Every month, the U.S. trade deﬁcit ﬁgures are announced. Foreign exchange traders often react to this announcement and even attempt to forecast the ﬁgures before they are announced. a. Why do you think the trade deﬁcit announcement sometimes has such an impact on foreign exchange trading? b. In some periods, foreign exchange traders do not respond to a trade deﬁcit announcement, even when the announced deﬁcit is very large. Offer an explanation for such a lack of response.

11. Comovements of Exchange Rates. Explain why the value of the British pound against the dollar will

Chapter 4: Exchange Rate Determination

not always move in tandem with the value of the euro against the dollar. 12. Factors Affecting Exchange Rates. In the 1990s, Russia was attempting to import more goods but had little to offer other countries in terms of potential exports. In addition, Russia’s inﬂation rate was high. Explain the type of pressure that these factors placed on the Russian currency. 13. National Income Effects. Analysts commonly attribute the appreciation of a currency to expectations that economic conditions will strengthen. Yet, this chapter suggests that when other factors are held constant, increased national income could increase imports and cause the local currency to weaken. In reality, other factors are not constant. What other factor is likely to be affected by increased economic growth and could place upward pressure on the value of the local currency? 14. Factors Affecting Exchange Rates. If the Asian countries experience a decline in economic growth (and experience a decline in inﬂation and interest rates as a result), how will their currency values (relative to the U.S. dollar) be affected? 15. Impact of Crises. Why do you think most crises in countries (such as the Asian crisis) cause the local currency to weaken abruptly? Is it because of trade or capital ﬂows? 16. Impact of September 11. The terrorist attacks on the United States on September 11, 2001, were expected to weaken U.S. economic conditions and reduce U.S. interest rates. How do you think the weaker U.S. economic conditions would have affected trade ﬂows? How would this have affected the value of the dollar (holding other factors constant)? How do you think the lower U.S. interest rates would have affected the value of the U.S. dollar (holding other factors constant)? Advanced Questions 17. Measuring Effects on Exchange Rates. Tarheel Co. plans to determine how changes in U.S. and Mexican real interest rates will affect the value of the U.S. dollar. (See Appendix C.)

99

States. Inﬂation and interest rates are much more volatile in Mexico than in industrialized countries. The value of the Mexican peso is typically more volatile than the currencies of industrialized countries from a U.S. perspective; it has typically depreciated from one year to the next, but the degree of depreciation has varied substantially. The bid/ask spread tends to be wider for the peso than for currencies of industrialized countries. a. Identify the most obvious economic reason for

the persistent depreciation of the peso. b. High interest rates are commonly expected to

strengthen a country’s currency because they can encourage foreign investment in securities in that country, which results in the exchange of other currencies for that currency. Yet, the peso’s value has declined against the dollar over most years even though Mexican interest rates are typically much higher than U.S. interest rates. Thus, it appears that the high Mexican interest rates do not attract substantial U.S. investment in Mexico’s securities. Why do you think U.S. investors do not try to capitalize on the high interest rates in Mexico? c. Why do you think the bid/ask spread is higher

for pesos than for currencies of industrialized countries? How does this affect a U.S. ﬁrm that does substantial business in Mexico? 19. Aggregate Effects on Exchange Rates. Assume that the United States invests heavily in government and corporate securities of Country K. In addition, residents of Country K invest heavily in the United States. Approximately $10 billion worth of investment transactions occur between these two countries each year. The total dollar value of trade transactions per year is about $8 million. This information is expected to also hold in the future. Because your ﬁrm exports goods to Country K, your job as international cash manager requires you to forecast the value of Country K’s currency (the “krank”) with respect to the dollar. Explain how each of the following conditions will affect the value of the krank, holding other things equal. Then, aggregate all of these impacts to develop an overall forecast of the krank’s movement against the dollar.

a. Describe a regression model that could be used to achieve this purpose. Also explain the expected sign of the regression coefﬁcient.

a. U.S. inﬂation has suddenly increased substan-

b. If Tarheel Co. thinks that the existence of a

while Country K’s interest rates remain low. Investors of both countries are attracted to high interest rates.

quota in particular historical periods may have affected exchange rates, how might this be accounted for in the regression model? 18. Factors Affecting Exchange Rates. Mexico tends to have much higher inﬂation than the United States and also much higher interest rates than the United

tially, while Country K’s inﬂation remains low. b. U.S. interest rates have increased substantially,

c. The U.S. income level increased substantially,

while Country K’s income level has remained unchanged.

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Part 1: The International Financial Environment d. The United States is expected to impose a small

tariff on goods imported from Country K. e. Combine all expected impacts to develop an

overall forecast. 20. Speculation. Blue Demon Bank expects that the Mexican peso will depreciate against the dollar from its spot rate of $.15 to $.14 in 10 days. The following interbank lending and borrowing rates exist: Currency

Lending Rate

Borrowing Rate

U.S. dollar

8.0%

8.3%

Mexican peso

8.5%

8.7%

Assume that Blue Demon Bank has a borrowing capacity of either $10 million or 70 million pesos in the interbank market, depending on which currency it wants to borrow. a. How could Blue Demon Bank attempt to capi-

talize on its expectations without using deposited funds? Estimate the proﬁts that could be generated from this strategy. b. Assume all the preceding information with this

exception: Blue Demon Bank expects the peso to appreciate from its present spot rate of $.15 to $.17 in 30 days. How could it attempt to capitalize on its expectations without using deposited funds? Estimate the proﬁts that could be generated from this strategy. 21. Speculation. Diamond Bank expects that the Singapore dollar will depreciate against the U.S. dollar from its spot rate of $.43 to $.42 in 60 days. The following interbank lending and borrowing rates exist: Currency U.S. dollar Singapore dollar

Lending Rate

Borrowing Rate

7.0%

7.2%

22.0%

24.0%

Diamond Bank considers borrowing 10 million Singapore dollars in the interbank market and investing the funds in U.S. dollars for 60 days. Estimate the proﬁts (or losses) that could be earned from this strategy. Should Diamond Bank pursue this strategy? 22. Relative Importance of Factors Affecting Exchange Rate Risk. Assume that the level of capital ﬂows between the United States and the country of Krendo is negligible (close to zero) and will continue to be negligible. There is a substantial

amount of trade between the United States and the country of Krendo and no capital ﬂows. How will high inﬂation and high interest rates affect the value of the kren (Krendo’s currency)? Explain. 23. Assessing the Euro’s Potential Movements. You reside in the United States and are planning to make a one-year investment in Germany during the next year. Since the investment is denominated in euros, you want to forecast how the euro’s value may change against the dollar over the one-year period. You expect that Germany will experience an inﬂation rate of 1 percent during the next year, while all other European countries will experience an inﬂation rate of 8 percent over the next year. You expect that the United States will experience an annual inﬂation rate of 2 percent during the next year. You believe that the primary factor that affects any exchange rate is the inﬂation rate. Based on the information provided in this question, will the euro appreciate, depreciate, or stay at about the same level against the dollar over the next year? Explain. 24. Weighing Factors That Affect Exchange Rates. Assume that the level of capital ﬂows between the United States and the country of Zeus is negligible (close to zero) and will continue to be negligible. There is a substantial amount of trade between the United States and the country of Zeus. The main import by the United States is basic clothing purchased by U.S. retail stores from Zeus, while the main import by Zeus is special computer chips that are only made in the United States and are needed by many manufacturers in Zeus. Suddenly, the U.S. government decides to impose a 20 percent tax on the clothing imports. The Zeus government immediately retaliates by imposing a 20 percent tax on the computer chip imports. Second, the Zeus government immediately imposes a 60 percent tax on any interest income that would be earned by Zeus investors if they buy U.S. securities. Third, the Zeus central bank raises its local interest rates so that they are now higher than interest rates in the United States. Do you think the currency of Zeus (called the zee) will appreciate or depreciate against the dollar as a result of all the government actions described above? Explain. Discussion in the Boardroom This exercise can be found in Appendix E at the back of this textbook. Running Your Own MNC This exercise can be found on the Xtra! website at http://maduraxtra.swlearning.com.

Chapter 4: Exchange Rate Determination

BLADES,

INC.

101

CASE

Assessment of Future Exchange Rate Movements As the chief ﬁnancial ofﬁcer of Blades, Inc., Ben Holt is pleased that his current system of exporting “Speedos” to Thailand seems to be working well. Blades’ primary customer in Thailand, a retailer called Entertainment Products, has committed itself to purchasing a ﬁxed number of Speedos annually for the next 3 years at a ﬁxed price denominated in baht, Thailand’s currency. Furthermore, Blades is using a Thai supplier for some of the components needed to manufacture Speedos. Nevertheless, Holt is concerned about recent developments in Asia. Foreign investors from various countries had invested heavily in Thailand to take advantage of the high interest rates there. As a result of the weak economy in Thailand, however, many foreign investors have lost conﬁdence in Thailand and have withdrawn their funds. Ben Holt has two major concerns regarding these developments. First, he is wondering how these changes in Thailand’s economy could affect the value of the Thai baht and, consequently, Blades. More speciﬁcally, he is wondering whether the effects on the Thai baht may affect Blades even though its primary Thai customer is committed to Blades over the next 3 years. Second, Holt believes that Blades may be able to speculate on the anticipated movement of the baht, but he is uncertain about the procedure needed to accomplish this. To facilitate Holt’s understanding of exchange rate speculation, he has asked you, Blades’ ﬁnancial analyst, to provide him with detailed illustrations of two scenarios. In the ﬁrst, the baht would move from a current level of $.022 to $.020 within the next 30 days. Under the second scenario, the baht would move from its current level to $.025 within the next 30 days. Based on Holt’s needs, he has provided you with the following list of questions to be answered:

assuming a change in the Thai baht’s value from a value of $.022 to $.026. 2. What are the basic factors that determine the value of a currency? In equilibrium, what is the relationship between these factors? 3. How might the relatively high levels of inﬂation and interest rates in Thailand affect the baht’s value? (Assume a constant level of U.S. inﬂation and interest rates.) 4. How do you think the loss of conﬁdence in the Thai baht, evidenced by the withdrawal of funds from Thailand, will affect the baht’s value? Would Blades be affected by the change in value, given the primary Thai customer’s commitment? 5. Assume that Thailand’s central bank wishes to prevent a withdrawal of funds from its country in order to prevent further changes in the currency’s value. How could it accomplish this objective using interest rates? 6. Construct a spreadsheet illustrating the steps Blades’ treasurer would need to follow in order to speculate on expected movements in the baht’s value over the next 30 days. Also show the speculative proﬁt (in dollars) resulting from each scenario. Use both of Ben Holt’s examples to illustrate possible speculation. Assume that Blades can borrow either $10 million or the baht equivalent of this amount. Furthermore, assume that the following short-term interest rates (annualized) are available to Blades: Currency Dollars Thai baht

1. How are percentage changes in a currency’s value measured? Illustrate your answer numerically by

SMALL

BUSINESS

Lending Rate

Borrowing Rate

8.10%

8.20%

14.80%

15.40%

DILEMMA

Assessment by the Sports Exports Company of Factors That Affect the British Pound’s Value Because the Sports Exports Company (a U.S. ﬁrm) receives payments in British pounds every month and converts those pounds into dollars, it needs to closely

monitor the value of the British pound in the future. Jim Logan, owner of the Sports Exports Company, expects that inﬂation will rise substantially in the

102

Part 1: The International Financial Environment

United Kingdom, while inﬂation in the United States will remain low. He also expects that the interest rates in both countries will rise by about the same amount.

2. Given Jim’s expectations, will the Sports Exports Company be favorably or unfavorably affected by the future changes in the value of the pound?

1. Given Jim’s expectations, forecast whether the pound will appreciate or depreciate against the dollar over time.

I N T E R N E T/ E XC E L The website of the Federal Reserve Board of Governors provides exchange rate trends of various currencies. Its address is http://www.federalreserve.gov/releases/. 1. Click on the section “Foreign Exchange Rates” monthly. Use this Web page to determine how exchange rates of various currencies have changed in recent months. Note that most of these currencies (except the British pound) are quoted in units per dollar. In general, have most currencies strengthened or weakened against the dollar over the last 3 months? Offer one or more reasons to explain the recent general movements in currency values against the dollar. 2. Does it appear that the Asian currencies move in the same direction relative to the dollar? Does it appear that the Latin American currencies move in the same direction against the dollar? Explain.

EXERCISES 3. Go to http://www.oanda.com/convert/fxhistory. Obtain the direct exchange rate ($ per currency unit) of the Canadian dollar for the beginning of each of the last 12 months. Insert this information in a column on an electronic spreadsheet. (See Appendix C for help on conducting analyses with Excel.) Repeat the process to obtain the direct exchange rate of the euro. Compute the percentage change in the value of the Canadian dollar and the euro each month. Determine the standard deviation of the movements (percentage changes) in the Canadian dollar and in the euro. Compare the standard deviation of the euro’s movements to the standard deviation of the Canadian dollar’s movements. Which currency is more volatile?

5: Currency Derivatives Given the potential shifts in the supply of or demand for currency (as explained in the previous chapter), ﬁrms and individuals who have assets denominated in foreign currencies can be affected favorably or unfavorably. They may want to alter their currency exposure in order to beneﬁt from the expected movements. In addition, some MNCs that expect to be adversely affected by the expected movements in exchange rates may wish to hedge their exposure. This chapter provides a background on currency derivatives, which are commonly traded to capitalize on or hedge against expected exchange rate movements. A currency derivative is a contract whose price is partially derived from the value of the underlying currency that it represents. Some individuals and ﬁnancial ﬁrms take

positions in currency derivatives to speculate on future exchange rate movements. MNCs commonly take positions in currency derivatives to hedge their exposure to exchange rate risk. Their managers must understand how these derivatives can be used to achieve corporate goals. The speciﬁc objectives of this chapter are to: ■ explain how forward contracts are used to hedge

based on anticipated exchange rate movements, ■ describe how currency futures contracts are used to

speculate or hedge based on anticipated exchange rate movements, and ■ explain how currency options contracts are used to

speculate or hedge based on anticipated exchange rate movements.

Forward Market The forward market facilitates the trading of forward contracts on currencies. A forward contract is an agreement between a corporation and a commercial bank to exchange a speciﬁed amount of a currency at a speciﬁed exchange rate (called the forward rate) on a speciﬁed date in the future. When multinational corporations (MNCs) anticipate a future need for or future receipt of a foreign currency, they can set up forward contracts to lock in the rate at which they can purchase or sell a particular foreign currency. Virtually all large MNCs use forward contracts. Some MNCs have forward contracts outstanding worth more than $100 million to hedge various positions. Because forward contracts accommodate large corporations, the forward transaction will often be valued at $1 million or more. Forward contracts normally are not used by consumers or small ﬁrms. In cases when a bank does not know a corporation well or fully trust it, the bank may request that the corporation make an initial deposit to assure that it will fulﬁll its obligation. Such a deposit is called a compensating balance and typically does not pay interest. The most common forward contracts are for 30, 60, 90, 180, and 360 days, although other periods (including longer periods) are available. The forward rate of a given currency will typically vary with the length (number of days) of the forward period.

103

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Part 1: The International Financial Environment

How MNCs Use Forward Contracts MNCs use forward contracts to hedge their imports. They can lock in the rate at which they obtain a currency needed to purchase imports. Turz, Inc., is an MNC based in Chicago that will need 1,000,000 Singapore dollars in 90 days to purchase Singapore imports. It can buy Singapore dollars for immediate delivery at the spot rate of $.50 per Singapore dollar (S$). At this spot rate, the ﬁrm would need $500,000 (computed as S$1,000,000 $.50 per Singapore dollar). However, it does not have the funds right now to exchange for Singapore dollars. It could wait 90 days and then exchange U.S. dollars for Singapore dollars at the spot rate existing at that time. But Turz does not know what the spot rate will be at that time. If the rate rises to $.60 by then, Turz will need $600,000 (computed as S$1,000,000 $.60 per Singapore dollar), an additional outlay of $100,000 due to the appreciation of the Singapore dollar. To avoid exposure to exchange rate risk, Turz can lock in the rate it will pay for Singapore dollars 90 days from now without having to exchange U.S. dollars for Singapore dollars immediately. Speciﬁcally, Turz can negotiate a forward contract with a bank to purchase S$1,000,000 90 days forward. ■

E X A M P L E

The ability of a forward contract to lock in an exchange rate can create an opportunity cost in some cases. Assume that in the previous example, Turz negotiated a 90-day forward rate of $.50 to purchase S$1,000,000. If the spot rate in 90 days is $.47, Turz will have paid $.03 per unit or $30,000 (1,000,000 units $.03) more for the Singapore dollars than if it did not have a forward contract. ■

E X A M P L E

Corporations also use the forward market to lock in the rate at which they can sell foreign currencies. This strategy is used to hedge against the possibility of those currencies depreciating over time. Scanlon, Inc., based in Virginia, exports products to a French ﬁrm and will receive payment of €400,000 in 4 months. It can lock in the amount of dollars to be received from this transaction by selling euros forward. That is, Scanlon can negotiate a forward contract with a bank to sell the €400,000 for U.S. dollars at a speciﬁed forward rate today. Assume the prevailing 4-month forward rate on euros is $1.10. In 4 months, Scanlon will exchange its €400,000 for $440,000 (computed as €400,000 $1.10 $440,000). ■

E X A M P L E

Bid/Ask Spread. Like spot rates, forward rates have a bid/ask spread. For example, a bank may set up a contract with one ﬁrm agreeing to sell the ﬁrm Singapore dollars 90 days from now at $.510 per Singapore dollar. This represents the ask rate. At the same time, the ﬁrm may agree to purchase (bid) Singapore dollars 90 days from now from some other ﬁrm at $.505 per Singapore dollar. The spread between the bid and ask prices is wider for forward rates of currencies of developing countries, such as Chile, Mexico, South Korea, Taiwan, and Thailand. Because these markets have relatively few orders for forward contracts, banks are less able to match up willing buyers and sellers. This lack of liquidity causes banks to widen the bid/ask spread when quoting forward contracts. The contracts in these countries are generally available only for short-term horizons. Premium or Discount on the Forward Rate. The difference between the forward rate (F) and the spot rate (S) at a given point in time is measured by the premium: F 5 S11 1 p2

Chapter 5: Currency Derivatives

105

where p represents the forward premium, or the percentage by which the forward rate exceeds the spot rate.

E X A M P L E

If the euro’s spot rate is $1.03, and its one-year forward rate has a forward premium of 2 percent, the one-year forward rate is:

F 5 S11 1 p2 5 $1.03 1 1 1 .02 2 5 $1.0506

■

Given quotations for the spot rate and the forward rate at a given point in time, the premium can be determined by rearranging the above equation: F 5 S11 1 p2 F/S 5 1 1 p

1 F/S 2 2 1 5 p

E X A M P L E

If the euro’s one-year forward rate is quoted at $1.0506 and the euro’s spot rate is quoted at $1.03, the euro’s forward premium is:

1 F/S 2 2 1 5 p 1 $1.0506/$1.03 2 2 1 5 p 1.02 2 1 5 .02 or 2 percent

■

When the forward rate is less than the prevailing spot rate, the forward premium is negative, and the forward rate exhibits a discount.

E X A M P L E

If the euro’s one-year forward rate is quoted at $1.00 and the euro’s spot rate is quoted at $1.03, the euro’s forward premium is:

1 F/S 2 2 1 5 p 1 $1.00/$1.03 2 2 1 5 p .9709 2 1 5 2.0291 or 22.91 percent Since p is negative, the forward rate contains a discount. ■

E X A M P L E

Assume the forward exchange rates of the British pound for various maturities are as shown in the second column of Exhibit 5.1. Based on each forward exchange rate, the forward discount can be computed on an annualized basis, as shown in Exhibit 5.1. ■

In some situations, a ﬁrm may prefer to assess the premium or discount on an unannualized basis. In this case, it would not include the fraction that represents the number of periods per year in the formula. Exhibit 5.1

Computation of Forward Rate Premiums or Discounts

Type of Exchange Rate for £

Value

Spot rate

$1.681

30-day forward rate

$1.680

90-day forward rate 180-day forward rate

$1.677 $1.672

Maturity

Forward Rate Premium or Discount for £

30 days

$1.680 $1.681

90 days

$1.681 $1.677 $1.681

180 days

$1.681 $1.672 $1.681 $1.681

360 30 360 90 360 180

.71% .95% 1.07%

106

Part 1: The International Financial Environment

Arbitrage. Forward rates typically differ from the spot rate for any given currency. If the forward rate were the same as the spot rate, and interest rates of the two countries differed, it would be possible for some investors (under certain assumptions) to use arbitrage to earn higher returns than would be possible domestically without incurring additional risk (as explained in Chapter 7). Consequently, the forward rate usually contains a premium (or discount) that reﬂects the difference between the home interest rate and the foreign interest rate. H T T P : // http://www.bmonesbittburns .com/economic/regular/ fxrates Forward rates of the Canadian dollar, British pound, euro, and Japanese yen for various periods. The website shows the forward rate of the British pound, the euro, and the Japanese yen against the Canadian dollar and against the U.S. dollar.

Movements in the Forward Rate over Time. If the forward rate’s premium remained constant, the forward rate would move in perfect tandem with the movements in the corresponding spot rate over time. For example, if the spot rate of the euro increased by 4 percent from a month ago until today, the forward rate would have to increase by 4 percent as well over the same period in order to maintain the same premium. In reality, the forward premium is inﬂuenced by the interest rate differential between the two countries (as explained in Chapter 7) and can change over time. Most of the movement in a currency’s forward rate over time is due to movements in that currency’s spot rate.

Offsetting a Forward Contract. In some cases, an MNC may desire to offset a forward contract that it previously created. On March 10, Green Bay, Inc., hired a Canadian construction company to expand its ofﬁce and agreed to pay C$200,000 for the work on September 10. It negotiated a 6-month forward contract to obtain C$200,000 at $.70 per unit, which would be used to pay the Canadian ﬁrm in 6 months. On April 10, the construction company informed Green Bay that it would not be able to perform the work as promised. Therefore, Green Bay offset its existing contract by negotiating a forward contract to sell C$200,000 for the date of September 10. However, the spot rate of the Canadian dollar had decreased over the last month, and the prevailing forward contract price for September 10 is $.66. Green Bay now has a forward contract to sell C$200,000 on September 10, which offsets the other contract it has to buy C$200,000 on September 10. The forward rate was $.04 per unit less on its forward sale than on its forward purchase, resulting in a cost of $8,000 (C$200,000 $.04). ■

E X A M P L E

If Green Bay in the preceding example negotiates the forward sale with the same bank where it negotiated the forward purchase, it may simply be able to request that its initial forward contract be offset. The bank will charge a fee for this service, which will reﬂect the difference between the forward rate at the time of the forward purchase and the forward rate at the time of the offset. Thus, the MNC cannot just ignore its obligation, but must pay a fee to offset its original obligation.

Using Forward Contracts for Swap Transactions. A swap transaction involves a spot transaction along with a corresponding forward contract that will ultimately reverse the spot transaction. Many forward contracts are negotiated for this purpose. Soho, Inc., needs to invest 1 million Chilean pesos in its Chilean subsidiary for the production of additional products. It wants the subsidiary to repay the pesos in one year. Soho wants to lock in the rate at which the pesos can be converted back into dollars in one year, and it uses a one-year forward contract for this purpose. Soho contacts its bank and requests the following swap transaction:

E X A M P L E

Chapter 5: Currency Derivatives

107

1. Today: The bank should withdraw dollars from Soho’s U.S. account, convert the dollars to pesos in the spot market, and transmit the pesos to the subsidiary’s account. 2. In one year: The bank should withdraw 1 million pesos from the subsidiary’s account, convert them to dollars at today’s forward rate, and transmit them to Soho’s U.S. account. Soho, Inc., is not exposed to exchange rate movements due to the transaction because it has locked in the rate at which the pesos will be converted back to dollars. If the one-year forward rate exhibits a discount, however, Soho will receive fewer dollars in one year than it invested in the subsidiary today. It may still be willing to engage in the swap transaction under these circumstances in order to remove uncertainty about the dollars it will receive in one year. ■

Non-Deliverable Forward Contracts A new type of forward contract called a non-deliverable forward contract (NDF) is frequently used for currencies in emerging markets. Like a regular forward contract, an NDF represents an agreement regarding a position in a speciﬁed amount of a speciﬁed currency, a speciﬁed exchange rate, and a speciﬁed future settlement date. However, an NDF does not result in an actual exchange of the currencies at the future date. That is, there is no delivery. Instead, one party to the agreement makes a payment to the other party based on the exchange rate at the future date. Jackson, Inc., an MNC based in Wyoming, determines as of April 1 that it will need 100 million Chilean pesos to purchase supplies on July 1. It can negotiate an NDF with a local bank as follows. The NDF will specify the currency (Chilean peso), the settlement date (90 days from now), and a so-called reference rate, which identiﬁes the type of exchange rate that will be marked to market at the settlement. Speciﬁcally, the NDF will contain the following information:

E X A M P L E

• Buy 100 million Chilean pesos. • Settlement date: July 1. • Reference index: Chilean peso’s closing exchange rate (in dollars) quoted by Chile’s central bank in 90 days. Assume that the Chilean peso (which is the reference index) is currently valued at $.0020, so the dollar amount of the position is $200,000 at the time of the agreement. At the time of the settlement date (July 1), the value of the reference index is determined, and a payment is made between the two parties to settle the NDF. For example, if the peso value increases to $.0023 by July 1, the value of the position speciﬁed in the NDF will be $230,000 ($.0023 100 million pesos). Since the value of Jackson’s NDF position is $30,000 higher than when the agreement was created, Jackson will receive a payment of $30,000 from the bank. Recall that Jackson needs 100 million pesos to buy imports. Since the peso’s spot rate rose from April 1 to July 1, Jackson will need to pay $30,000 more for the imports than if it had paid for them on April 1. At the same time, however, Jackson will have received a payment of $30,000 due to its NDF. Thus, the NDF hedged the exchange rate risk. If the Chilean peso had depreciated to $.0018 instead of rising, Jackson’s position in its NDF would have been valued at $180,000 (100 million pesos $.0018) at the settlement date, which is $20,000 less than the value when the agreement was created. Therefore, Jackson would have owed the bank $20,000 at that time. However, the decline in the spot rate of the peso means that Jackson would pay $20,000 less for the imports than if it had paid for them on April 1. Thus, an offsetting effect would also occur in this example. ■

As these examples show, although an NDF does not involve delivery, it can effectively hedge future foreign currency payments that are anticipated by an MNC.

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Since an NDF can specify that any payments between the two parties be in dollars or some other available currency, ﬁrms can even use NDFs to hedge existing positions of foreign currencies that are not convertible. Consider an MNC that expects to receive payment in a foreign currency that cannot be converted into dollars. Though the MNC may use the currency to make purchases in the local country of concern, it still may desire to hedge against a decline in the value of the currency over the period before it receives payment. It takes a sell position in an NDF and uses the closing exchange rate of that currency as of the settlement date as the reference index. If the currency depreciates against the dollar over time, the ﬁrm will receive the difference between the dollar value of the position when the NDF contract was created and the dollar value of the position as of the settlement date. Thus, it will receive a payment in dollars from the NDF to offset any depreciation in the currency over the period of concern.

H T T P : // http://www.futuresmag.com/ library/contents.html Various aspects of derivatives trading such as new products, strategies, and market analyses.

Currency Futures Market Currency futures contracts are contracts specifying a standard volume of a particular

currency to be exchanged on a speciﬁc settlement date. Thus, currency futures contracts are similar to forward contracts in terms of their obligation, but differ from forward contracts in the way they are traded. They are commonly used by MNCs to hedge their foreign currency positions. In addition, they are traded by speculators who hope to capitalize on their expectations of exchange rate movements. A buyer of a currency futures contract locks in the exchange rate to be paid for a foreign currency at a future point in time. Alternatively, a seller of a currency futures contract locks in the exchange rate at which a foreign currency can be exchanged for the home currency. In the United States, currency futures contracts are purchased to lock in the amount of dollars needed to obtain a speciﬁed amount of a particular foreign currency; they are sold to lock in the amount of dollars to be received from selling a speciﬁed amount of a particular foreign currency.

Contract Speciﬁcations H T T P : // http://www.cme.com Time series on ﬁnancial futures and option prices. The site also allows for the generation of historic price charts.

Currency futures contracts are available for several widely traded currencies at the Chicago Mercantile Exchange (CME); the contract for each currency speciﬁes a standardized number of units (see Exhibit 5.2). The typical currency futures contract is based on a currency value in terms of U.S. dollars. However, futures contracts are also available on some cross-rates, such as the exchange rate between the Australian dollar and the Canadian dollar. Thus, speculators who expect that the Australian dollar will move substantially against the Canadian dollar can take a futures position to capitalize on their expectations. In addition, Australian ﬁrms that have exposure in Canadian dollars or Canadian ﬁrms that have exposure in Australian dollars may use this type of futures contract to hedge their exposure. See http://www.cme.com for more information about futures on cross exchange rates. Currency futures contracts typically specify the third Wednesday in March, June, September, or December as the settlement date. There is also an over-the-counter currency futures market, where ﬁnancial intermediaries facilitate trading of currency futures contracts with speciﬁc settlement dates. Contracts have to be standardized, or ﬂoor trading would slow down considerably while brokers assessed contract speciﬁcations.

Trading Futures Firms or individuals can execute orders for currency futures contracts by calling brokerage ﬁrms that serve as intermediaries. The order to buy or sell a currency futures

Chapter 5: Currency Derivatives Exhibit 5.2

109

Currency Futures Contracts Traded on the Chicago Mercantile Exchange

Currency

Units per Contract

Australian dollar

100,000

Brazilian real

100,000

British pound

62,500

Canadian dollar Czech koruna Euro

100,000 4,000,000 125,000

Hungarian forint

30,000,000

Japanese yen

12,500,000

Mexican peso

500,000

New Zealand dollar

100,000

Norwegian krone Polish zloty Russian ruble South African rand Swedish krona Swiss franc

2,000,000 500,000 2,500,000 500,000 2,000,000 125,000

contract for a speciﬁc currency and a speciﬁc settlement date is communicated to the brokerage ﬁrm, which in turn communicates the order to the CME. A ﬂoor broker at the CME who specializes in that type of currency futures contract stands at a speciﬁc spot at the trading pit where that type of contract is traded and attempts to ﬁnd a counterparty to fulﬁll the order. For example, if an MNC wants to purchase a Mexican peso futures contract with a December settlement date, the ﬂoor broker assigned to execute this order will look for another ﬂoor broker who has an order to sell a Mexican peso futures contract with a December settlement date. Trading on the ﬂoor (in the trading pits) of the CME takes place from 7:20 A.M. to 2:00 P.M. (Chicago time) Monday through Friday. Currency futures contracts can also be traded on the CME’s automated order-entry and matching system called GLOBEX, which typically is open 23 hours per day (closed from 4 P.M. to 5 P.M.). The GLOBEX system matches buy and sell orders for each type of currency futures contract. E-mini futures for some currencies are also traded on the GLOBEX system; they specify half the number of units of the standard futures contract. When participants in the currency futures market take a position, they need to establish an initial margin, which may represent as little as 10 percent of the contract value. The margin required is in the form of cash for small investors or Treasury securities for institutional investors. In addition to the initial margin, participants are subject to a variation margin, which is intended to accumulate a sufﬁcient amount of funds to back the futures position. Full-service brokers typically charge a commission of about $50 for a round-trip trade in currency futures, while discount brokers charge a commission of about $20. Some Internet brokers also trade currency futures.

E X X A M P L E

Assume that as of February 10, a futures contract on 62,500 British pounds with a March settlement date is priced at $1.50 per pound. The buyer of this currency fu-

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Part 1: The International Financial Environment tures contract will receive £62,500 on the March settlement date and will pay $93,750 for the pounds (computed as £62,500 $1.50 per pound plus a commission paid to the broker). The seller of this contract is obligated to sell £62,500 at a price of $1.50 per pound and therefore will receive $93,750 on the settlement date, minus the commission that it owes the broker. ■

Comparison of Currency Futures and Forward Contracts Currency futures contracts are similar to forward contracts in that they allow a customer to lock in the exchange rate at which a speciﬁc currency is purchased or sold for a speciﬁc date in the future. Nevertheless, there are some differences between currency futures contracts and forward contracts, which are summarized in Exhibit 5.3. Currency futures contracts are sold on an exchange, while each forward contract is negotiated between a ﬁrm and a commercial bank over a telecommunications network. Thus, forward contracts can be tailored to the needs of the ﬁrm, while currency futures contracts are standardized. Corporations that have established relationships with large banks tend to use forward contracts rather than futures contracts because forward contracts are tailored to the precise amount of currency to be purchased or sold in the future and the precise forward date that they prefer. Conversely, small ﬁrms and individuals who do not have established relationships with large banks or prefer to trade in smaller amounts tend to use currency futures contracts.

Pricing Currency Futures The price of currency futures normally will be similar to the forward rate for a given currency and settlement date. This relationship is enforced by the potential arbitrage activity that would occur if there were signiﬁcant discrepancies.

E X A M P L E Exhibit 5.3

Assume that the currency futures price on the British pound is $1.50 and that forward contracts for a similar period are available for $1.48. Firms may attempt to purchase

Comparison of the Forward and Futures Markets Forward

Futures

Size of contract

Tailored to individual needs.

Standardized.

Delivery date

Tailored to individual needs.

Standardized.

Participants

Banks, brokers, and multinational companies. Public speculation not encouraged.

Banks, brokers, and multinational companies. Qualiﬁed public speculation encouraged.

Security deposit

None as such, but compensating bank balances or lines of credit required.

Small security deposit required.

Clearing operation

Handling contingent on individual banks and brokers. No separate clearinghouse function.

Handled by exchange clearinghouse. Daily settlements to the market price.

Marketplace

Telecommunications network.

Central exchange ﬂoor with worldwide communications.

Regulation

Self-regulating.

Commodity Futures Trading Commission; National Futures Association.

Liquidation

Most settled by actual delivery. Some by offset, at a cost.

Most by offset, very few by delivery.

Transaction costs

Set by “spread” between bank’s buy and sell prices.

Negotiated brokerage fees.

Source: Chicago Mercantile Exchange.

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111

forward contracts and simultaneously sell currency futures contracts. If they can exactly match the settlement dates of the two contracts, they can generate guaranteed proﬁts of $.02 per unit. These actions will place downward pressure on the currency futures price. The futures contract and forward contracts of a given currency and settlement date should have the same price, or else guaranteed proﬁts are possible (assuming no transaction costs). ■

H T T P : // http://www.cme.com Provides the open price, high and low prices for the day, closing (last) price, and trading volume.

The currency futures price differs from the spot rate for the same reasons that a forward rate differs from the spot rate. If a currency’s spot and futures prices were the same and the currency’s interest rate were higher than the U.S. rate, U.S. speculators could lock in a higher return than they would receive on U.S. investments. They could purchase the foreign currency at the spot rate, invest the funds at the attractive interest rate, and simultaneously sell currency futures to lock in the exchange rate at which they could reconvert the currency back to dollars. If the spot and futures rates were the same, there would be neither a gain nor a loss on the currency conversion. Thus, the higher foreign interest rate would provide a higher yield on this type of investment. The actions of investors to capitalize on this opportunity would place upward pressure on the spot rate and downward pressure on the currency futures price, causing the futures price to fall below the spot rate.

Credit Risk of Currency Futures Contracts Each currency futures contract represents an agreement between a client and the exchange clearinghouse, even though the exchange has not taken a position. To illustrate, assume you call a broker to request the purchase of a British pound futures contract with a March settlement date. Meanwhile, another person unrelated to you calls a broker to request the sale of a similar futures contract. Neither party needs to worry about the credit risk of the counterparty. The exchange clearinghouse assures that you will receive whatever is owed to you as a result of your currency futures position. To minimize its risk in such a guarantee, the CME imposes margin requirements to cover ﬂuctuations in the value of a contract, meaning that the participants must make a deposit with their respective brokerage ﬁrms when they take a position. The initial margin requirement is typically between $1,000 and $2,000 per currency futures contract. However, if the value of the futures contract declines over time, the buyer may be asked to add to the initial margin. Margin requirements are not always required for forward contracts due to the more personal nature of the agreement; the bank knows the ﬁrm it is dealing with and may trust it to fulﬁll its obligation.

Speculation with Currency Futures Currency futures contracts are sometimes purchased by speculators who are simply attempting to capitalize on their expectation of a currency’s future movement. Assume that speculators expect the British pound to appreciate in the future. They can purchase a futures contract that will lock in the price at which they buy pounds at a speciﬁed settlement date. On the settlement date, they can purchase their pounds at the rate speciﬁed by the futures contract and then sell these pounds at the spot rate. If the spot rate has appreciated by this time in accordance with their expectations, they will proﬁt from this strategy. ■

E X A M P L E

Currency futures are often sold by speculators who expect that the spot rate of a currency will be less than the rate at which they would be obligated to sell it.

E X A M P L E

Assume that as of April 4, a futures contract specifying 500,000 Mexican pesos and a June settlement date is priced at $.09. On April 4, speculators who expect the peso

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Part 1: The International Financial Environment will decline sell futures contracts on pesos. Assume that on June 17 (the settlement date), the spot rate of the peso is $.08. The transactions are shown in Exhibit 5.4 (the margin deposited by the speculators is not considered). The gain on the futures position is $5,000, which represents the difference between the amount received ($45,000) when selling the pesos in accordance with the futures contract versus the amount paid ($40,000) for those pesos in the spot market. ■

Of course, expectations are often incorrect. It is because of different expectations that some speculators decide to purchase futures contracts while other speculators decide to sell the same contracts at a given point in time.

Currency Futures Market Efﬁciency. If the currency futures market is efﬁcient, the futures price for a currency at any given point in time should reﬂect all available information. That is, it should represent an unbiased estimate of the respective currency’s spot rate on the settlement date. Thus, the continual use of a particular strategy to take positions in currency futures contracts should not lead to abnormal proﬁts. Some positions will likely result in gains while others will result in losses, but over time, the gains and losses should offset. Research has found that in some years, the futures price has consistently exceeded the corresponding price as of the settlement date, while in other years, the futures price has consistently been below the corresponding price as of the settlement date. This suggests that the currency futures market may be inefﬁcient. However, the patterns are not necessarily observable until after they occur, which means that it may be difﬁcult to consistently generate abnormal proﬁts from speculating in currency futures.

How Firms Use Currency Futures Corporations that have open positions in foreign currencies can consider purchasing or selling futures contracts to offset their positions.

Purchasing Futures to Hedge Payables. The purchase of futures contracts locks in the price at which a ﬁrm can purchase a currency. Teton Co. orders Canadian goods and upon delivery will need to send C$500,000 to the Canadian exporter. Thus, Teton purchases Canadian dollar futures contracts today, thereby locking in the price to be paid for Canadian dollars at a future settlement date. By holding futures contracts, Teton does not have to worry about changes in the spot rate of the Canadian dollar over time. ■

E X A M P L E

Exhibit 5.4

Source of Gains from Buying Currency Futures June 17 (Settlement Date)

April 4

...................................... Step 1: Contract to Sell $.09 per peso p500,000 $45,000 at the settlement date

.....................................

Step 2: Buy Pesos (Spot) $.08 per peso p500,000 Pay $40,000

Step 3: Sell the Pesos for $45,000 to Fulﬁll Futures Contract

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Selling Futures to Hedge Receivables. The sale of futures contracts locks in the price at which a ﬁrm can sell a currency. Karla Co. sells futures contracts when it plans to receive a currency from exporting that it will not need (it accepts a foreign currency when the importer prefers that type of payment). By selling a futures contract, Karla Co. locks in the price at which it will be able to sell this currency as of the settlement date. Such an action can be appropriate if Karla expects the foreign currency to depreciate against Karla’s home currency. ■

E X A M P L E

The use of futures contracts to cover, or hedge, a ﬁrm’s currency positions is described more thoroughly in Chapter 11.

Closing Out a Futures Position If a ﬁrm that buys a currency futures contract decides before the settlement date that it no longer wants to maintain its position, it can close out the position by selling an identical futures contract. The gain or loss to the ﬁrm from its previous futures position is dependent on the price of purchasing futures versus selling futures. The price of a futures contract changes over time in accordance with movements in the spot rate and also with changing expectations about the spot rate’s value as of the settlement date. If the spot rate of a currency increases substantially over a one-month period, the futures price will likely increase by about the same amount. In this case, the purchase and subsequent sale of a futures contract would be proﬁtable. Conversely, a decline in the spot rate over time will correspond with a decline in the currency futures price, meaning that the purchase and subsequent sale of a futures contract would result in a loss. While the purchasers of the futures contract could decide not to close out their position under such conditions, the losses from that position could increase over time. On January 10, Tacoma Co. anticipates that it will need Australian dollars (A$) in March when it orders supplies from an Australian supplier. Consequently, Tacoma purchases a futures contract specifying A$100,000 and a March settlement date (which is March 19 for this contract). On January 10, the futures contract is priced at $.53 per A$. On February 15, Tacoma realizes that it will not need to order supplies because it has reduced its production levels. Therefore, it has no need for A$ in March. It sells a futures contract on A$ with the March settlement date to offset the contract it purchased in January. At this time, the futures contract is priced at $.50 per A$. On March 19 (the settlement date), Tacoma has offsetting positions in futures contracts. However, the price when the futures contract was purchased was higher than the price when an identical contract was sold, so Tacoma incurs a loss from its futures positions. Tacoma’s transactions are summarized in Exhibit 5.5. Move from left to right along the time line to review the transactions. The example does not include margin requirements. ■

E X X A M P L E

Exhibit 5.5

Closing Out a Futures Contract

January 10

February 15

...................................... Step 1: Contract to Buy $.53 per A$ A$100,000 $53,000 at the settlement date

March 19 (Settlement Date)

.....................................

Step 2: Contract to Sell $.50 per A$ A$100,000 $50,000 at the settlement date

Step 3: Settle Contracts $53,000 (Contract 1) $50,000 (Contract 2) $3,000 loss

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Sellers of futures contracts can close out their positions by purchasing currency futures contracts with similar settlement dates. Most currency futures contracts are closed out before the settlement date.

Trading Platforms for Currency Futures There are electronic trading platforms that facilitate the trading of currency futures. These platforms serve as a broker, as they execute the trades desired. The platform typically sets quotes for currency futures based on an ask price at which one can buy a speciﬁed currency for a speciﬁed settlement date, and a bid price at which one can sell a speciﬁed currency. Users of the platforms incur a fee in the form of a difference between the bid and ask prices.

Currency Options Market Currency options provide the right to purchase or sell currencies at speciﬁed prices. They are available for many currencies, including the Australian dollar, British pound, Brazilian real, Canadian dollar, euro, Japanese yen, Mexican peso, New Zealand dollar, Russian ruble, South African rand, and Swiss franc.

Option Exchanges In late 1982, exchanges in Amsterdam, Montreal, and Philadelphia ﬁrst allowed trading in standardized foreign currency options. Since that time, options have been offered on the Chicago Mercantile Exchange and the Chicago Board Options Exchange. Currency options are traded through the GLOBEX system at the Chicago Mercantile Exchange, even after the trading ﬂoor is closed. Thus, currency options are traded virtually around the clock. The options exchanges in the United States are regulated by the Securities and Exchange Commission. Options can be purchased or sold through brokers for a commission. The commission per transaction is commonly $30 to $60 for a single currency option, but it can be much lower per contract when the transaction involves multiple contracts. Brokers require that a margin be maintained during the life of the contract. The margin is increased for clients whose option positions have deteriorated. This protects against possible losses if the clients do not fulﬁll their obligations.

Over-the-Counter Market In addition to the exchanges where currency options are available, there is an overthe-counter market where currency options are offered by commercial banks and brokerage ﬁrms. Unlike the currency options traded on an exchange, the over-thecounter market offers currency options that are tailored to the speciﬁc needs of the ﬁrm. Since these options are not standardized, all the terms must be speciﬁed in the contracts. The number of units, desired strike price, and expiration date can be tailored to the speciﬁc needs of the client. When currency options are not standardized, there is less liquidity and a wider bid/ask spread. The minimum size of currency options offered by ﬁnancial institutions is normally about $5 million. Since these transactions are conducted with a speciﬁc ﬁnancial institution rather than an exchange, there are no credit guarantees. Thus, the agreement made is only as safe as the parties involved. For this reason, ﬁnancial institutions may require some collateral from individuals or ﬁrms desiring to purchase or sell currency options. Currency options are classiﬁed as either calls or puts, as discussed in the next section.

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Currency Call Options A currency call option grants the right to buy a speciﬁc currency at a designated price within a speciﬁc period of time. The price at which the owner is allowed to buy that currency is known as the exercise price or strike price, and there are monthly expiration dates for each option. Call options are desirable when one wishes to lock in a maximum price to be paid for a currency in the future. If the spot rate of the currency rises above the strike price, owners of call options can “exercise” their options by purchasing the currency at the strike price, which will be cheaper than the prevailing spot rate. This strategy is somewhat similar to that used by purchasers of futures contracts, but the futures contracts require an obligation, while the currency option does not. The owner can choose to let the option expire on the expiration date without ever exercising it. Owners of expired call options will have lost the premium they initially paid, but that is the most they can lose. Currency options quotations are summarized each day in various ﬁ nancial newspapers. Although currency options typically expire near the middle of the speciﬁed month, some of them expire at the end of the speciﬁc month and are designated as EOM. Some options are listed as “European Style,” which means that they can be exercised only upon expiration. A currency call option is said to be in the money when the present exchange rate exceeds the strike price, at the money when the present exchange rate equals the strike price, and out of the money when the present exchange rate is less than the strike price. For a given currency and expiration date, an in-the-money call option will require a higher premium than options that are at the money or out of the money.

Factors Affecting Currency Call Option Premiums The premium on a call option represents the cost of having the right to buy the underlying currency at a speciﬁed price. For MNCs that use currency call options to hedge, the premium reﬂects a cost of insurance or protection to the MNCs. The call option premium (referred to as C) is primarily inﬂuenced by three factors:

H T T P : // http://www.ino.com The latest information and prices of options and ﬁnancial futures as well as the corresponding historic price charts.

C 5 f 1 S 2 X, T, s 2

where S X represents the difference between the spot exchange rate (S) and the strike or exercise price (X), T represents the time to maturity, and s represents the volatility of the currency, as measured by the standard deviation of the movements in the currency. The relationships between the call option premium and these factors are summarized next. • Level of existing spot price relative to strike price. The higher the spot rate relative to the strike price, the higher the option price will be. This is due to the higher probability of buying the currency at a substantially lower rate than what you could sell it for. This relationship can be veriﬁed by comparing premiums of options for a speciﬁed currency and expiration date that have different strike prices. • Length of time before the expiration date. It is generally expected that the spot rate has a greater chance of rising high above the strike price if it has a longer period of time to do so. A settlement date in June allows two additional months beyond April for the spot rate to move above the strike price. This explains why June option prices exceed April option prices given a speciﬁc strike price. This

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relationship can be veriﬁed by comparing premiums of options for a speciﬁed currency and strike price that have different expiration dates. • Potential variability of currency. The greater the variability of the currency, the higher the probability that the spot rate can rise above the strike price. Thus, less volatile currencies have lower call option prices. For example, the Canadian dollar is more stable than most other currencies. If all other factors are similar, Canadian call options should be less expensive than call options on other foreign currencies. The potential currency variability can also vary over time for a particular currency. For example, at the beginning of the Asian crisis in 1997, the Asian countries experienced ﬁnancial problems, and their currency values were subject to much more uncertainty. Consequently, the premium on over-the-counter options of Asian currencies such as the Thai baht, Indonesian rupiah, and Korean won increased. The higher premium was necessary to compensate those who were willing to sell options in these currencies, as the risk to sellers had increased because the currencies had become more volatile.

How Firms Use Currency Call Options Corporations with open positions in foreign currencies can sometimes use currency call options to cover these positions.

Using Call Options to Hedge Payables. MNCs can purchase call options on a currency to hedge future payables. When Pike Co. of Seattle orders Australian goods, it makes a payment in Australian dollars to the Australian exporter upon delivery. An Australian dollar call option locks in a maximum rate at which Pike can exchange dollars for Australian dollars. This exchange of currencies at the speciﬁed strike price on the call option contract can be executed at any time before the expiration date. In essence, the call option contract speciﬁes the maximum price that Pike must pay to obtain these Australian imports. If the Australian dollar’s value remains below the strike price, Pike can purchase Australian dollars at the prevailing spot rate when it needs to pay for its imports and simply let its call option expire. ■

E X A M P L E

Options may be more appropriate than futures or forward contracts for some situations. Intel Corp. uses options to hedge its order backlog in semiconductors. If an order is canceled, it has the ﬂexibility to let the option contract expire. With a forward contract, it would be obligated to fulﬁll its obligation even though the order was canceled.

Using Call Options to Hedge Project Bidding. U.S.-based MNCs that bid for foreign projects may purchase call options to lock in the dollar cost of the potential expenses. Kelly Co. is an MNC based in Fort Lauderdale that has bid on a project sponsored by the Canadian government. If the bid is accepted, Kelly will need approximately C$500,000 to purchase Canadian materials and services. However, Kelly will not know whether the bid is accepted until 3 months from now. In this case, it can purchase call options with a 3-month expiration date. Ten call option contracts will cover the entire amount of potential exposure. If the bid is accepted, Kelly can use the options to purchase the Canadian dollars needed. If the Canadian dollar has depreciated over time, Kelly will likely let the options expire. Assume that the exercise price on Canadian dollars is $.70 and the call option premium is $.02 per unit. Kelly will pay $1,000 per option (since there are 50,000 units per Canadian

E X A M P L E

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dollar option), or $10,000 for the 10 option contracts. With the options, the maximum amount necessary to purchase the C$500,000 is $350,000 (computed as $.70 per Canadian dollar C$500,000). The amount of U.S. dollars needed would be less if the Canadian dollar’s spot rate were below the exercise price at the time the Canadian dollars were purchased. Even if Kelly’s bid is rejected, it will exercise the currency call option if the Canadian dollar’s spot rate exceeds the exercise price before the option expires and would then sell the Canadian dollars in the spot market. Any gain from exercising may partially or even fully offset the premium paid for the options. ■

This type of example is quite common. When Air Products and Chemicals was hired to perform some projects, it needed capital equipment from Germany. The purchase of equipment was contingent on whether the ﬁrm was hired for the projects. The company used options to hedge this possible future purchase.

Using Call Options to Hedge Target Bidding. Firms can also use call options to hedge a possible acquisition. Morrison Co. is attempting to acquire a French ﬁrm and has submitted its bid in euros. Morrison has purchased call options on the euro because it will need euros to purchase the French company’s stock. The call options hedge the U.S. ﬁrm against the potential appreciation of the euro by the time the acquisition occurs. If the acquisition does not occur and the spot rate of the euro remains below the strike price, Morrison Co. can let the call options expire. If the acquisition does not occur and the spot rate of the euro exceeds the strike price, Morrison Co. can exercise the options and sell the euros in the spot market. Alternatively, Morrison Co. can sell the call options it is holding. Either of these actions may offset part or all of the premium paid for the options. ■

E X A M P L E

Speculating with Currency Call Options Because this text focuses on multinational ﬁnancial management, the corporate use of currency options is more important than the speculative use. The use of options for hedging is discussed in detail in Chapter 11. Speculative trading is discussed here in order to provide more of a background on the currency options market. Individuals may speculate in the currency options market based on their expectation of the future movements in a particular currency. Speculators who expect that a foreign currency will appreciate can purchase call options on that currency. Once the spot rate of that currency appreciates, the speculators can exercise their options by purchasing that currency at the strike price and then sell the currency at the prevailing spot rate. Just as with currency futures, for every buyer of a currency call option there must be a seller. A seller (sometimes called a writer) of a call option is obligated to sell a speciﬁed currency at a speciﬁed price (the strike price) up to a speciﬁed expiration date. Speculators may sometimes want to sell a currency call option on a currency that they expect will depreciate in the future. The only way a currency call option will be exercised is if the spot rate is higher than the strike price. Thus, a seller of a currency call option will receive the premium when the option is purchased and can keep the entire amount if the option is not exercised. When it appears that an option will be exercised, there will still be sellers of options. However, such options will sell for high premiums due to the high risk that the option will be exercised at some point. The net proﬁt to a speculator who trades call options on a currency is based on a comparison of the selling price of the currency versus the exercise price paid for the currency and the premium paid for the call option.

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Part 1: The International Financial Environment Jim is a speculator who buys a British pound call option with a strike price of $1.40 and a December settlement date. The current spot price as of that date is about $1.39. Jim pays a premium of $.012 per unit for the call option. Assume there are no brokerage fees. Just before the expiration date, the spot rate of the British pound reaches $1.41. At this time, Jim exercises the call option and then immediately sells the pounds at the spot rate to a bank. To determine Jim’s proﬁt or loss, ﬁrst compute his revenues from selling the currency. Then, subtract from this amount the purchase price of pounds when exercising the option, and also subtract the purchase price of the option. The computations follow. Assume one option contract speciﬁes 31,250 units.

E X A M P L E

Per Unit

Per Contract

Selling price of £

$1.41

$44,063 ($1.41 31,250 units)

Purchase price of £

1.40

43,750 ($1.40 31,250 units)

Premium paid for option Net proﬁt

.012

375 ($.012 31,250 units)

$.002

$62 ($.002 31,250 units)

Assume that Linda was the seller of the call option purchased by Jim. Also assume that Linda would purchase British pounds only if and when the option was exercised, at which time she must provide the pounds at the exercise price of $1.40. Using the information in this example, Linda’s net proﬁt from selling the call option is derived here:

Per Unit

Per Contract

Selling price of £

$1.40

$43,750 ($1.40 31,250 units)

Purchase price of £

1.41

44,063 ($1.41 31,250 units)

Premium received

.012

375 ($.012 31,250 units)

Net proﬁt

$.002

$62 ($.002 31,250 units)

As a second example, assume the following information: • Call option premium on Canadian dollars (C$) $.01 per unit. • Strike price $.70. • One Canadian dollar option contract represents C$50,000. A speculator who had purchased this call option decided to exercise the option shortly before the expiration date, when the spot rate reached $.74. The speculator immediately sold the Canadian dollars in the spot market. Given this information, the net proﬁt to the speculator is computed as follows:

Per Unit

Per Contract

Selling price of C$

$.74

$37,000 ($.74 50,000 units)

Purchase price of C$

.70

35,000 ($.70 50,000 units)

Premium paid for option

.01

500 ($.01 50,000 units)

Net proﬁt

$.03

$1,500 ($.03 50,000 units)

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119

If the seller of the call option did not obtain Canadian dollars until the option was about to be exercised, the net proﬁt to the seller of the call option was Per Unit

Per Contract

Selling price of C$

$.70

$35,000 ($.70 50,000 units)

Purchase price of C$

.74

37,000 ($.74 50,000 units)

Premium received Net proﬁt

.01

500 ($.01 50,000 units)

$.03

$1,500 ($.03 50,000 units)

When brokerage fees are ignored, the currency call purchaser’s gain will be the seller’s loss. The currency call purchaser’s expenses represent the seller’s revenues, and the purchaser’s revenues represent the seller’s expenses. Yet, because it is possible for purchasers and sellers of options to close out their positions, the relationship described here will not hold unless both parties begin and close out their positions at the same time. An owner of a currency option may simply sell the option to someone else before the expiration date rather than exercising it. The owner can still earn proﬁts since the option premium changes over time, reﬂecting the probability that the option can be exercised and the potential proﬁt from exercising it.

Break-Even Point from Speculation. The purchaser of a call option will break even if the revenue from selling the currency equals the payments for (1) the currency (at the strike price) and (2) the option premium. In other words, regardless of the number of units in a contract, a purchaser will break even if the spot rate at which the currency is sold is equal to the strike price plus the option premium. Based on the information in the previous example, the strike price is $.70 and the option premium is $.01. Thus, for the purchaser to break even, the spot rate existing at the time the call is exercised must be $.71 ($.70 $.01). Of course, speculators will not purchase a call option if they think the spot rate will only reach the break-even point and not go higher before the expiration date. Nevertheless, the computation of the break-even point is useful for a speculator deciding whether to purchase a currency call option. ■

E X A M P L E

Currency Put Options The owner of a currency put option receives the right to sell a currency at a speciﬁed price (the strike price) within a speciﬁed period of time. As with currency call options, the owner of a put option is not obligated to exercise the option. Therefore, the maximum potential loss to the owner of the put option is the price (or premium) paid for the option contract. A currency put option is said to be in the money when the present exchange rate is less than the strike price, at the money when the present exchange rate equals the strike price, and out of the money when the present exchange rate exceeds the strike price. For a given currency and expiration date, an in-the-money put option will require a higher premium than options that are at the money or out of the money.

Factors Affecting Currency Put Option Premiums The put option premium (referred to as P) is primarily inﬂuenced by three factors: P 5 f 1 S 2 X, T, s 2

■

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where S X represents the difference between the spot exchange rate (S) and the strike or exercise price (X), T represents the time to maturity, and s represents the volatility of the currency, as measured by the standard deviation of the movements in the currency. The relationships between the put option premium and these factors, which also inﬂuence call option premiums as described earlier, are summarized next. First, the spot rate of a currency relative to the strike price is important. The lower the spot rate relative to the strike price, the more valuable the put option will be, because there is a higher probability that the option will be exercised. Recall that just the opposite relationship held for call options. A second factor inﬂuencing the put option premium is the length of time until the expiration date. As with currency call options, the longer the time to expiration, the greater the put option premium will be. A longer period creates a higher probability that the currency will move into a range where it will be feasible to exercise the option (whether it is a put or a call). These relationships can be veriﬁed by assessing quotations of put option premiums for a speciﬁed currency. A third factor that inﬂuences the put option premium is the variability of a currency. As with currency call options, the greater the variability, the greater the put option premium will be, again reﬂecting a higher probability that the option may be exercised.

Hedging with Currency Put Options Corporations with open positions in foreign currencies can use currency put options in some cases to cover these positions. Assume Duluth Co. has exported products to Canada and invoiced the products in Canadian dollars (at the request of the Canadian importers). Duluth is concerned that the Canadian dollars it is receiving will depreciate over time. To insulate itself against possible depreciation, Duluth purchases Canadian dollar put options, which entitle it to sell Canadian dollars at the speciﬁed strike price. In essence, Duluth locks in the minimum rate at which it can exchange Canadian dollars for U.S. dollars over a speciﬁed period of time. If the Canadian dollar appreciates over this time period, Duluth can let the put options expire and sell the Canadian dollars it receives at the prevailing spot rate. ■

E X A M P L E

At a given point in time, some put options are deep out of the money, meaning that the prevailing exchange rate is high above the exercise price. These options are cheaper (have a lower premium), as they are unlikely to be exercised because their exercise price is too low. At the same time, other put options have an exercise price that is currently above the prevailing exchange rate and are therefore more likely to be exercised. Consequently, these options are more expensive. Cisco Systems weighs the tradeoff when using put options to hedge the remittance of earnings from Europe to the United States. It can create a hedge that is cheap, but the options can be exercised only if the currency’s spot rate declines substantially. Alternatively, Cisco can create a hedge that can be exercised at a more favorable exchange rate, but it must pay a higher premium for the options. If Cisco’s goal in using put options is simply to prevent a major loss if the currency weakens substantially, it may be willing to use an inexpensive put option (low exercise price, low premium). However, if its goal is to ensure that the currency can be exchanged at a more favorable exchange rate, Cisco will use a more expensive put option (high exercise price, high premium). By selecting currency options with an exercise price and premium that ﬁts their objectives, Cisco and other MNCs can increase their value. ■

E X A M P L E

Speculating with Currency Put Options Individuals may speculate with currency put options based on their expectations of the future movements in a particular currency. For example, speculators who expect that the British pound will depreciate can purchase British pound put options, which

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121

will entitle them to sell British pounds at a speciﬁed strike price. If the pound’s spot rate depreciates as expected, the speculators can then purchase pounds at the spot rate and exercise their put options by selling these pounds at the strike price. Speculators can also attempt to proﬁt from selling currency put options. The seller of such options is obligated to purchase the speciﬁed currency at the strike price from the owner who exercises the put option. Speculators who believe the currency will appreciate (or at least will not depreciate) may sell a currency put option. If the currency appreciates over the entire period, the option will not be exercised. This is an ideal situation for put option sellers since they keep the premiums received when selling the options and bear no cost. The net proﬁt to a speculator from trading put options on a currency is based on a comparison of the exercise price at which the currency can be sold versus the purchase price of the currency and the premium paid for the put option.

E X A M P L E

A put option contract on British pounds speciﬁes the following information:

• Put option premium on British pound (£) $.04 per unit. • Strike price $1.40. • One option contract represents £31,250. A speculator who had purchased this put option decided to exercise the option shortly before the expiration date, when the spot rate of the pound was $1.30. The speculator purchased the pounds in the spot market at that time. Given this information, the net proﬁt to the purchaser of the put option is calculated as follows: Per Unit

Per Contract

Selling price of £

$1.40

$43,750 ($1.40 31,250 units)

Purchase price of £

1.30

40,625 ($1.30 31,250 units)

Premium paid for option

.04

1,250 ($.04 31,250 units)

Net proﬁt

$.06

$ 1,875 ($.06 31,250 units)

Assuming that the seller of the put option sold the pounds received immediately after the option was exercised, the net proﬁt to the seller of the put option is calculated as follows: Per Unit

Per Contract

Selling price of £

$1.30

$40,625 ($1.30 31,250 units)

Purchase price of £

1.40

43,750 ($1.40 31,250 units)

Premium received

.04

1,250 ($.04 31,250 units)

$.06

$1,875 ($.06 31,250 units)

Net proﬁt

The seller of the put options could simply refrain from selling the pounds (after being forced to buy them at $1.40 per pound) until the spot rate of the pound rises. However, there is no guarantee that the pound will reverse its direction and begin to appreciate. The seller’s net loss could potentially be greater if the pound’s spot rate continued to fall, unless the pounds were sold immediately. Whatever an owner of a put option gains, the seller loses, and vice versa. This relationship would hold if brokerage costs did not exist and if the buyer and seller of

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options entered and closed their positions at the same time. Brokerage fees for currency options exist, however, and are very similar in magnitude to those of currency futures contracts.

Speculating with Combined Put and Call Options. For volH T T P : // http://www.phlx.com/ products/currency/currency .html Contract speciﬁcations and volume information for the currency options contracts that are traded on the Philadelphia Stock Exchange.

atile currencies, one possible speculative strategy is to create a straddle, which uses both a put option and a call option at the same exercise price. This may seem unusual because owning a put option is appropriate for expectations that the currency will depreciate while owning a call option is appropriate for expectations that the currency will appreciate. However, it is possible that the currency will depreciate (at which time the put is exercised) and then reverse direction and appreciate (allowing for proﬁts when exercising the call). Also, a speculator might anticipate that a currency will be substantially affected by current economic events yet be uncertain of the exact way it will be affected. By purchasing a put option and a call option, the speculator will gain if the currency moves substantially in either direction. Although two options are purchased and only one is exercised, the gains could more than offset the costs.

Currency Options Market Efﬁciency. If the currency options market is efﬁcient, the premiums on currency options properly reﬂect all available information. Under these conditions, it may be difﬁcult for speculators to consistently generate abnormal proﬁts when speculating in this market. Research has found that the currency options market is efﬁcient after controlling for transaction costs. Although some trading strategies could have generated abnormal gains in speciﬁc periods, they would have generated large losses if implemented in other periods. It is difﬁcult to know which strategy would generate abnormal proﬁts in future periods.

Contingency Graphs for Currency Options A contingency graph for currency options illustrates the potential gain or loss for various exchange rate scenarios.

Contingency Graph for a Purchaser of a Call Option A contingency graph for a purchaser of a call option compares the price paid for the call option to potential payoffs to be received with various exchange rate scenarios. A British pound call option is available, with a strike price of $1.50 and a call premium of $.02. The speculator plans to exercise the option on the expiration date (if appropriate at that time) and then immediately sell the pounds received in the spot market. Under these conditions, a contingency graph can be created to measure the proﬁt or loss per unit (see the upper-left graph in Exhibit 5.6). Notice that if the future spot rate is $1.50 or less, the net gain per unit is $.02 (ignoring transaction costs). This represents the loss of the premium per unit paid for the option, as the option would not be exercised. At $1.51, $.01 per unit would be earned by exercising the option, but considering the $.02 premium paid, the net gain would be $.01. At $1.52, $.02 per unit would be earned by exercising the option, which would offset the $.02 premium per unit. This is the break-even point. At any rate above this point, the gain from exercising the option would more than offset the premium, resulting in a positive net gain. The maximum loss to the speculator in this example is the premium paid for the option. ■

E X A M P L E

Chapter 5: Currency Derivatives Exhibit 5.6

Contingency Graphs for Currency Options

Contingency Graph for Purchasers of British Pound Put Options

Contingency Graph for Purchasers of British Pound Call Options

Net Proﬁt per Unit

+$.04 +$.02

+$.06

Exercise Price = $1.50 Premium = $ .02 Future Spot Rate $1.46 $1.48 $1.50 $1.52 $1.54

–$.02

+$.04 Net Proﬁt per Unit

+$.06

+$.02

–$.06

–$.06

Contingency Graph for Sellers of British Pound Put Options

Contingency Graph for Sellers of British Pound Call Options

Future Spot Rate

+$.04 Net Proﬁt per Unit

Net Proﬁt per Unit

$1.46 $1.48 $1.50 $1.52 $1.54

–$.02

+$.06

Exercise Price = $1.50 Premium = $ .02

+$.02

Future Spot Rate $1.46 $1.48 $1.50 $1.52 $1.54

–$.04

+$.04

Exercise Price = $1.50 Premium = $ .03

–$.02

–$.04

+$.06

123

Exercise Price = $1.50 Premium = $ .03

+$.02

$1.46 $1.48 $1.50 $1.52 $1.54

–$.02

–$.04

–$.04

–$.06

–$.06

Future Spot Rate

Contingency Graph for a Seller of a Call Option A contingency graph for the seller of a call option compares the premium received from selling a call option to the potential payoffs made to the buyer of the call option for various exchange rate scenarios. The lower-left graph shown in Exhibit 5.6 provides a contingency graph for a speculator who sold the call option described in the previous example. It assumes that this seller would purchase the pounds in the spot market just as the option was exercised (ignoring transaction costs). At future spot rates of less than $1.50, the net gain to the seller would be the premium of $.02 per unit, as the option would not have been exercised. If the future spot rate is $1.51, the seller would lose $.01 per unit on the option transaction (paying $1.51 for pounds in the spot market and selling pounds for $1.50 to fulﬁll the exercise request). Yet, this loss would be more than offset by the premium of $.02 per unit received, resulting in a net gain of $.01 per unit.

E X A M P L E

124

Part 1: The International Financial Environment The break-even point is at $1.52, and the net gain to the seller of a call option becomes negative at all future spot rates higher than that point. Notice that the contingency graphs for the buyer and seller of this call option are mirror images of one another. ■

Contingency Graph for a Buyer of a Put Option A contingency graph for a buyer of a put option compares the premium paid for the put option to potential payoffs received for various exchange rate scenarios. The upper-right graph in Exhibit 5.6 shows the net gains to a buyer of a British pound put option with an exercise price of $1.50 and a premium of $.03 per unit. If the future spot rate is above $1.50, the option will not be exercised. At a future spot rate of $1.48, the put option will be exercised. However, considering the premium of $.03 per unit, there will be a net loss of $.01 per unit. The break-even point in this example is $1.47, since this is the future spot rate that will generate $.03 per unit from exercising the option to offset the $.03 premium. At any future spot rates of less than $1.47, the buyer of the put option will earn a positive net gain. ■

E X A M P L E

Contingency Graph for a Seller of a Put Option A contingency graph for the seller of this put option compares the premium received from selling the option to the possible payoffs made to the buyer of the put option for various exchange rate scenarios. The graph is shown in the lower-right graph in Exhibit 5.6. It is the mirror image of the contingency graph for the buyer of a put option. For various reasons, an option buyer’s net gain will not always represent an option seller’s net loss. The buyer may be using call options to hedge a foreign currency, rather than to speculate. In this case, the buyer does not evaluate the options position taken by measuring a net gain or loss; the option is used simply for protection. In addition, sellers of call options on a currency in which they currently maintain a position will not need to purchase the currency at the time an option is exercised. They can simply liquidate their position in order to provide the currency to the person exercising the option. Should an MNC’s Managers Use Currency Derivatives to Speculate? Managers of MNCs may be tempted to use currency derivatives for speculation. However, such actions are not consistent with the general operations of an MNC. In addition, this may increase the risk of the MNC and adversely affect its reputation. Some creditors may no longer lend funds to an MNC if they believe the funds may be used to gamble in the foreign exchange market. An MNC’s board of directors governs the actions of managers and can impose guidelines that prevent speculation with currency derivatives. In addition, it can ensure that the structure of management compensation would not reward managers that speculated in currency derivatives. ■

G GO V E R N A N NC CE E

Conditional Currency Options A currency option can be structured with a conditional premium, meaning that the premium paid for the option is conditioned on the actual movement in the currency’s value over the period of concern. Jensen Co., a U.S.-based MNC, needs to sell British pounds that it will receive in 60 days. It can negotiate a traditional currency put option on pounds in which the exercise price is $1.70 and the premium is $.02 per unit. Alternatively, it can negotiate a conditional currency option with a commercial bank, which has an exercise price of $1.70 and a so-called trigger of $1.74. If the pound’s value falls below the exercise price by the expiration date, Jensen will exercise the option, thereby receiving $1.70 per pound, and it will not have to pay a premium for the option.

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125

If the pound’s value is between the exercise price ($1.70) and the trigger ($1.74), the option will not be exercised, and Jensen will not need to pay a premium. If the pound’s value exceeds the trigger of $1.74, Jensen will pay a premium of $.04 per unit. Notice that this premium may be higher than the premium that would be paid for a basic put option. Jensen may not mind this outcome, however, because it will be receiving a high dollar amount from converting its pound receivables in the spot market. Jensen must determine whether the potential advantage of the conditional option (avoiding the payment of a premium under some conditions) outweighs the potential disadvantage (paying a higher premium than the premium for a traditional put option on British pounds). The potential advantage and disadvantage are illustrated in Exhibit 5.7. At exchange rates less than or equal to the trigger level ($1.74), the conditional option results in a larger payment to Jensen by the amount of the premium that would have been paid for the basic option. Conversely, at exchange rates above the trigger level, the conditional option results in a lower payment to Jensen, as its premium of $.04 exceeds the premium of $.02 per unit paid on a basic option. ■

The choice of a basic option versus a conditional option is dependent on expectations of the currency’s exchange rate over the period of concern. A ﬁrm that was very conﬁdent that the pound’s value would not exceed $1.74 in the previous example would prefer the conditional currency option. Conditional currency options are also available for U.S. ﬁrms that need to purchase a foreign currency in the near future. A conditional call option on pounds may specify an exercise price of $1.70 and a trigger of $1.67. If the pound’s value remains above the trigger of the call option, a premium will not have to be paid for the call option. However, if the pound’s value falls below the trigger, a large premium (such as $.04 per unit) will be required. Some conditional options require a

E X X A M P L E

Exhibit 5.7

$1.76 $1.74

Comparison of Conditional and Basic Currency Options

Conditional Put Option

Basic Put Option Conditional Put Option

Net Amount Received

$1.72 $1.70 $1.68 $1.66 $1.64 $1.62

Basic Put Option: Exercise Price $1.70, Premium $.02. Conditional Put Option: Exercise Price $1.70, Trigger $1.74, Premium $.04.

$1.60

$1.60 $1.62 $1.64 $1.66 $1.68 $1.70 $1.72 $1.74 $1.76 $1.78 $1.80 Spot Rate

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Part 1: The International Financial Environment premium if the trigger is reached anytime up until the expiration date; others require a premium only if the exchange rate is beyond the trigger as of the expiration date. ■

Firms also use various combinations of currency options. For example, a ﬁrm may purchase a currency call option to hedge payables and ﬁnance the purchase of the call option by selling a put option on the same currency.

European Currency Options The discussion of currency options up to this point has dealt solely with Americanstyle options. European-style currency options are also available for speculating and hedging in the foreign exchange market. They are similar to American-style options except that they must be exercised on the expiration date if they are to be exercised at all. Consequently, they do not offer as much ﬂexibility; however, this is not relevant to some situations. For example, ﬁrms that purchase options to hedge future foreign currency cash ﬂows will probably not desire to exercise their options before the expiration date anyway. If European-style options are available for the same expiration date as American-style options and can be purchased for a slightly lower premium, some corporations may prefer them for hedging.

SUMMARY ■ A forward contract speciﬁes a standard volume of a particular currency to be exchanged on a particular date. Such a contract can be purchased by a ﬁrm to hedge payables or sold by a ﬁrm to hedge receivables. ■ A currency futures contract can be purchased by speculators who expect the currency to appreciate. Conversely, it can be sold by speculators who expect that currency to depreciate. If the currency depreciates, the value of the futures contract declines, allowing those speculators to beneﬁt when they close out their positions. ■ Futures contracts on a particular currency can be purchased by corporations that have payables in that currency and wish to hedge against the possible appreciation of that currency. Conversely, these contracts can be sold by corporations that have receivables in that currency and wish to hedge against the possible depreciation of that currency.

POINT

■ Currency options are classiﬁed as call options or put options. Call options allow the right to purchase a speciﬁed currency at a speciﬁed exchange rate by a speciﬁed expiration date. Put options allow the right to sell a speciﬁed currency at a speciﬁed exchange rate by a speciﬁed expiration date. ■ Call options on a speciﬁc currency can be purchased by speculators who expect that currency to appreciate. Put options on a speciﬁc currency can be purchased by speculators who expect that currency to depreciate. ■ Currency call options are commonly purchased by corporations that have payables in a currency that is expected to appreciate. Currency put options are commonly purchased by corporations that have receivables in a currency that is expected to depreciate.

COUNTER-POINT

Should Speculators Use Currency Futures or Options? Point Speculators should use currency futures because they can avoid a substantial premium. To the extent that they are willing to speculate, they must

have conﬁdence in their expectations. If they have sufﬁcient conﬁdence in their expectations, they should bet on their expectations without having to pay a large

Chapter 5: Currency Derivatives

premium to cover themselves if they are wrong. If they do not have conﬁdence in their expectations, they should not speculate at all. Counter-Point Speculators should use currency options to ﬁt the degree of their conﬁdence. For example, if they are very conﬁdent that a currency will appreciate substantially, but want to limit their investment, they can buy deep out-of-the-money options. These options have a high exercise price but a low premium and therefore require a small investment. Alternatively, they can buy options that have a lower exercise

SELF

127

price (higher premium), which will likely generate a greater return if the currency appreciates. Speculation involves risk. Speculators must recognize that their expectations may be wrong. While options require a premium, the premium is worthwhile to limit the potential downside risk. Options enable speculators to select the degree of downside risk that they are willing to tolerate. Who Is Correct? Use the Internet to learn more about this issue. Which argument do you support? Offer your own opinion on this issue.

TEST

Answers are provided in Appendix A at the back of the text. 1. A call option on Canadian dollars with a strike price of $.60 is purchased by a speculator for a premium of $.06 per unit. Assume there are 50,000 units in this option contract. If the Canadian dollar’s spot rate is $.65 at the time the option is exercised, what is the net proﬁt per unit and for one contract to the speculator? What would the spot rate need to be at the time the option is exercised for the speculator to break even? What is the net proﬁt per unit to the seller of this option?

premium of $.02. If the Australian dollar’s spot rate is $.74 on the expiration date, should the speculator exercise the option on this date or let the option expire? What is the net proﬁt per unit to the speculator? What is the net proﬁt per unit to the seller of this put option? 3. Longer-term currency options are becoming more popular for hedging exchange rate risk. Why do you think some ﬁrms decide to hedge by using other techniques instead of purchasing long-term currency options?

2. A put option on Australian dollars with a strike price of $.80 is purchased by a speculator for a

QUESTIONS

AND

A P P L I CAT I O N S

1. Forward versus Futures Contracts. Compare and contrast forward and futures contracts. 2. Using Currency Futures. a. How can currency futures be used by

corporations? b. How can currency futures be used by speculators?

3. Currency Options. Differentiate between a currency call option and a currency put option. 4. Forward Premium. Compute the forward discount or premium for the Mexican peso whose 90-day forward rate is $.102 and spot rate is $.10. State whether your answer is a discount or premium. 5. Effects of a Forward Contract. How can a forward contract backﬁre? 6. Hedging with Currency Options. When would a U.S. ﬁrm consider purchasing a call option on euros for hedging? When would a U.S. ﬁrm consider purchasing a put option on euros for hedging?

7. Speculating with Currency Options. When should a speculator purchase a call option on Australian dollars? When should a speculator purchase a put option on Australian dollars? 8. Currency Call Option Premiums. List the factors that affect currency call option premiums and brieﬂy explain the relationship that exists for each. Do you think an at-the-money call option in euros has a higher or lower premium than an at-the-money call option in Mexican pesos (assuming the expiration date and the total dollar value represented by each option are the same for both options)? 9. Currency Put Option Premiums. List the factors that affect currency put option premiums and brieﬂy explain the relationship that exists for each. 10. Speculating with Currency Call Options. Randy Rudecki purchased a call option on British pounds for $.02 per unit. The strike price was $1.45, and the spot rate at the time the option was exercised

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was $1.46. Assume there are 31,250 units in a British pound option. What was Randy’s net proﬁt on this option? 11. Speculating with Currency Put Options. Alice Duever purchased a put option on British pounds for $.04 per unit. The strike price was $1.80, and the spot rate at the time the pound option was exercised was $1.59. Assume there are 31,250 units in a British pound option. What was Alice’s net proﬁt on the option? 12. Selling Currency Call Options. Mike Suerth sold a call option on Canadian dollars for $.01 per unit. The strike price was $.76, and the spot rate at the time the option was exercised was $.82. Assume Mike did not obtain Canadian dollars until the option was exercised. Also assume that there are 50,000 units in a Canadian dollar option. What was Mike’s net proﬁt on the call option? 13. Selling Currency Put Options. Brian Tull sold a put option on Canadian dollars for $.03 per unit. The strike price was $.75, and the spot rate at the time the option was exercised was $.72. Assume Brian immediately sold off the Canadian dollars received when the option was exercised. Also assume that there are 50,000 units in a Canadian dollar option. What was Brian’s net proﬁt on the put option? 14. Forward versus Currency Option Contracts. What are the advantages and disadvantages to a U.S. corporation that uses currency options on euros rather than a forward contract on euros to hedge its exposure in euros? Explain why an MNC may use forward contracts to hedge committed transactions and use currency options to hedge contracts that are anticipated but not committed. Why might

a. Georgetown Co. plans to purchase Japanese goods denominated in yen. b. Harvard, Inc., will sell goods to Japan, denominated in yen. c. Yale Corp. has a subsidiary in Australia that will be remitting funds to the U.S. parent. d. Brown, Inc., needs to pay off existing loans that are denominated in Canadian dollars. e. Princeton Co. may purchase a company in Japan in the near future (but the deal may not go through).

forward contracts be advantageous for committed transactions, and currency options be advantageous for anticipated transactions? 15. Speculating with Currency Futures. Assume that the euro’s spot rate has moved in cycles over time. How might you try to use futures contracts on euros to capitalize on this tendency? How could you determine whether such a strategy would have been proﬁtable in previous periods? 16. Hedging with Currency Derivatives. Assume that the transactions listed in the ﬁrst column of the table below are anticipated by U.S. ﬁrms that have no other foreign transactions. Place an “X” in the table wherever you see possible ways to hedge each of the transactions. 17. Price Movements of Currency Futures. Assume that on November 1, the spot rate of the British pound was $1.58 and the price on a December futures contract was $1.59. Assume that the pound depreciated during November so that by November 30 it was worth $1.51. a. What do you think happened to the futures price over the month of November? Why? b. If you had known that this would occur, would you have purchased or sold a December futures contract in pounds on November 1? Explain.

18. Speculating with Currency Futures. Assume that a March futures contract on Mexican pesos was available in January for $.09 per unit. Also assume that forward contracts were available for the same settlement date at a price of $.092 per peso. How could speculators capitalize on this situation, assuming zero transaction costs? How would such speculative

Forward Contract

Futures Contract

Options Contract

Forward Purchase

Buy Futures

Purchase a Call

Forward Sale

Sell Futures

Purchase a Put

Chapter 5: Currency Derivatives

activity affect the difference between the forward contract price and the futures price? 19. Speculating with Currency Call Options. LSU Corp. purchased Canadian dollar call options for speculative purposes. If these options are exercised, LSU will immediately sell the Canadian dollars in the spot market. Each option was purchased for a premium of $.03 per unit, with an exercise price of $.75. LSU plans to wait until the expiration date before deciding whether to exercise the options. Of course, LSU will exercise the options at that time only if it is feasible to do so. In the following table, ﬁll in the net proﬁt (or loss) per unit to LSU Corp. based on the listed possible spot rates of the Canadian dollar on the expiration date.

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21. Speculating with Currency Call Options. Bama Corp. has sold British pound call options for speculative purposes. The option premium was $.06 per unit, and the exercise price was $1.58. Bama will purchase the pounds on the day the options are exercised (if the options are exercised) in order to fulﬁll its obligation. In the following table, ﬁll in the net proﬁt (or loss) to Bama Corp. if the listed spot rate exists at the time the purchaser of the call options considers exercising them. Possible Spot Rate at the Time Purchaser of Call Options Considers Exercising Them

Net Proﬁt (Loss) per Unit to Bama Corp.

$1.53 Possible Spot Rate of Canadian Dollar on Expiration Date

Net Proﬁt (Loss) per Unit to LSU Corp.

1.55 1.57

$.76

1.60

.78

1.62

.80

1.64

.82

1.68

.85 .87

20. Speculating with Currency Put Options. Auburn Co. has purchased Canadian dollar put options for speculative purposes. Each option was purchased for a premium of $.02 per unit, with an exercise price of $.86 per unit. Auburn Co. will purchase the Canadian dollars just before it exercises the options (if it is feasible to exercise the options). It plans to wait until the expiration date before deciding whether to exercise the options. In the following table, ﬁll in the net proﬁt (or loss) per unit to Auburn Co. based on the listed possible spot rates of the Canadian dollar on the expiration date. Possible Spot Rate of Canadian Dollar on Expiration Date $.76 .79 .84 .87 .89 .91

Net Proﬁt (Loss) per Unit to Auburn Co.

22. Speculating with Currency Put Options. Bulldog, Inc., has sold Australian dollar put options at a premium of $.01 per unit, and an exercise price of $.76 per unit. It has forecasted the Australian dollar’s lowest level over the period of concern as shown in the following table. Determine the net proﬁt (or loss) per unit to Bulldog, Inc., if each level occurs and the put options are exercised at that time. Possible Value of Australian Dollar

Net Proﬁt (Loss) to Bulldog, Inc. If Value Occurs

$.72 .73 .74 .75 .76

23. Hedging with Currency Derivatives. A U.S. professional football team plans to play an exhibition game in the United Kingdom next year. Assume that all expenses will be paid by the British government, and that the team will receive a check for 1 million pounds. The team anticipates that the pound will depreciate substantially by the scheduled date of the game. In addition, the National Football League must approve the deal,

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and approval (or disapproval) will not occur for 3 months. How can the team hedge its position? What is there to lose by waiting 3 months to see if the exhibition game is approved before hedging? Advanced Questions 24. Risk of Currency Futures. Currency futures markets are commonly used as a means of capitalizing on shifts in currency values, because the value of a futures contract tends to move in line with the change in the corresponding currency value. Recently, many currencies appreciated against the dollar. Most speculators anticipated that these currencies would continue to strengthen and took large buy positions in currency futures. However, the Fed intervened in the foreign exchange market by immediately selling foreign currencies in exchange for dollars, causing an abrupt decline in the values of foreign currencies (as the dollar strengthened). Participants that had purchased currency futures contracts incurred large losses. One ﬂoor broker responded to the effects of the Fed’s intervention by immediately selling 300 futures contracts on British pounds (with a value of about $30 million). Such actions caused even more panic in the futures market. a. Explain why the central bank’s intervention

caused such panic among currency futures traders with buy positions. b. Explain why the ﬂoor broker’s willingness to sell

300 pound futures contracts at the going market rate aroused such concern. What might this action signal to other brokers? c. Explain why speculators with short (sell) posi-

tions could beneﬁt as a result of the central bank’s intervention. d. Some traders with buy positions may have re-

sponded immediately to the central bank’s intervention by selling futures contracts. Why would some speculators with buy positions leave their positions unchanged or even increase their positions by purchasing more futures contracts in response to the central bank’s intervention? 25. Estimating Proﬁts from Currency Futures and Options. One year ago, you sold a put option on 100,000 euros with an expiration date of one year. You received a premium on the put option of $.04 per unit. The exercise price was $1.22. Assume that one year ago, the spot rate of the euro was $1.20, the one-year forward rate exhibited a discount of 2 percent, and the one-year futures price was the same as the one-year forward rate. From one year ago to today, the euro depreciated against the dollar by 4 percent. Today the put option will be exercised (if it is feasible for the buyer to do so).

a. Determine the total dollar amount of your proﬁt or loss from your position in the put option. b. Now assume that instead of taking a position in the put option one year ago, you sold a futures contract on 100,000 euros with a settlement date of one year. Determine the total dollar amount of your proﬁt or loss.

26. Impact of Information on Currency Futures and Options Prices. Myrtle Beach Co. purchases imports that have a price of 400,000 Singapore dollars, and it has to pay for the imports in 90 days. It can purchase a 90-day forward contract on Singapore dollars at $.50 or purchase a call option contract on Singapore dollars with an exercise price of $.50. This morning, the spot rate of the Singapore dollar was $.50. At noon, the central bank of Singapore raised interest rates, while there was no change in interest rates in the United States. These actions immediately increased the degree of uncertainty surrounding the future value of the Singapore dollar over the next 3 months. The Singapore dollar’s spot rate remained at $.50 throughout the day. a. Myrtle Beach Co. is convinced that the Singapore dollar will deﬁ nitely appreciate substantially over the next 90 days. Would a call option hedge or forward hedge be more appropriate given its opinion? b. Assume that Myrtle Beach uses a currency options contract to hedge rather than a forward contract. If Myrtle Beach Co. purchased a currency call option contract at the money on Singapore dollars this afternoon, would its total U.S. dollar cash outﬂows be MORE THAN, LESS THAN, or THE SAME AS the total U.S. dollar cash outﬂows if it had purchased a currency call option contract at the money this morning? Explain.

27. Currency Straddles. Reska, Inc., has constructed a long euro straddle. A call option on euros with an exercise price of $1.10 has a premium of $.025 per unit. A euro put option has a premium of $.017 per unit. Some possible euro values at option expiration are shown in the following table. (See Appendix B in this chapter.) Value of Euro at Option Expiration $.90

$1.05

$1.50

$2.00

Call Put Net a. Complete the worksheet and determine the net proﬁt per unit to Reska, Inc., for each possible future spot rate.

Chapter 5: Currency Derivatives b. Determine the break-even point(s) of the long straddle. What are the break-even points of a short straddle using these options? 28. Currency Straddles. Refer to the previous question, but assume that the call and put option premiums are $.02 per unit and $.015 per unit, respectively. (See Appendix B in this chapter.) a. Construct a contingency graph for a long euro straddle. b. Construct a contingency graph for a short euro straddle. 29. Currency Option Contingency Graphs. (See Appendix B in this chapter.) The current spot rate of the Singapore dollar (S$) is $.50. The following option information is available: • Call option premium on Singapore dollar (S$) $.015. • Put option premium on Singapore dollar (S$) $.009. • Call and put option strike price $.55. • One option contract represents S$70,000. Construct a contingency graph for a short straddle using these options. 30. Speculating with Currency Straddles. Maggie Hawthorne is a currency speculator. She has noticed that recently the euro has appreciated substantially against the U.S. dollar. The current exchange rate of the euro is $1.15. After reading a variety of articles on the subject, she believes that the euro will continue to ﬂuctuate substantially in the months to come. Although most forecasters believe that the euro will depreciate against the dollar in the near future, Maggie thinks that there is also a good possibility of further appreciation. Currently, a call option on euros is available with an exercise price of $1.17 and a premium of $.04. A euro put option with an exercise price of $1.17 and a premium of $.03 is also available. (See Appendix B in this chapter.) a. Describe how Maggie could use straddles to speculate on the euro’s value. b. At option expiration, the value of the euro is $1.30. What is Maggie’s total proﬁt or loss from a long straddle position? c. What is Maggie’s total proﬁt or loss from a long straddle position if the value of the euro is $1.05 at option expiration? d. What is Maggie’s total proﬁt or loss from a long straddle position if the value of the euro at option expiration is still $1.15? e. Given your answers to the questions above, when

is it advantageous for a speculator to engage in a long straddle? When is it advantageous to engage in a short straddle?

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31. Currency Strangles. (See Appendix B in this chapter.) Assume the following options are currently available for British pounds (£): • Call option premium on British pounds $.04

per unit. • Put option premium on British pounds $.03

per unit. • Call option strike price $1.56. • Put option strike price $1.53. • One option contract represents £31,250. a. Construct a worksheet for a long strangle using

these options. b. Determine the break-even point(s) for a strangle. c. If the spot price of the pound at option expira-

tion is $1.55, what is the total proﬁt or loss to the strangle buyer? d. If the spot price of the pound at option expira-

tion is $1.50, what is the total proﬁt or loss to the strangle writer? 32. Currency Straddles. Refer to the previous question, but assume that the call and put option premiums are $.035 per unit and $.025 per unit, respectively. (See Appendix B in this chapter.) a. Construct a contingency graph for a long pound

straddle. b. Construct a contingency graph for a short pound

straddle. 33. Currency Strangles. The following information is currently available for Canadian dollar (C$) options (see Appendix B in this chapter): • Put option exercise price $.75. • Put option premium $.014 per unit. • Call option exercise price $.76. • Call option premium $.01 per unit. • One option contract represents C$50,000. a. What is the maximum possible gain the pur-

chaser of a strangle can achieve using these options? b. What is the maximum possible loss the writer of

a strangle can incur? c. Locate the break-even point(s) of the strangle.

34. Currency Strangles. For the following options available on Australian dollars (A$), construct a worksheet and contingency graph for a long strangle. Locate the break-even points for this strangle. (See Appendix B in this chapter.) • Put option strike price $.67. • Call option strike price $.65. • Put option premium $.01 per unit. • Call option premium $.02 per unit.

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35. Speculating with Currency Options. Barry Egan is a currency speculator. Barry believes that the Japanese yen will ﬂuctuate widely against the U.S. dollar in the coming month. Currently, one-month call options on Japanese yen (¥) are available with a strike price of $.0085 and a premium of $.0007 per unit. One-month put options on Japanese yen are available with a strike price of $.0084 and a premium of $.0005 per unit. One option contract on Japanese yen contains ¥6.25 million. (See Appendix B in this chapter.) a. Describe how Barry Egan could utilize these

options to speculate on the movement of the Japanese yen.

a. Describe how a bull spread can be constructed using these put options. What is the difference between using put options versus call options to construct a bull spread? b. Complete the following worksheet.

Value of British Pound at Option Expiration $1.55

$1.60

$1.62

$1.67

Put @ $1.60 Put @ $1.62 Net

b. Assume Barry decides to construct a long stran-

gle in yen. What are the break-even points of this strangle? c. What is Barry’s total proﬁt or loss if the value of

the yen in one month is $.0070? d. What is Barry’s total proﬁt or loss if the value of

the yen in one month is $.0090? 36. Currency Bull Spreads and Bear Spreads. A call option on British pounds (£) exists with a strike price of $1.56 and a premium of $.08 per unit. Another call option on British pounds has a strike price of $1.59 and a premium of $.06 per unit. (See Appendix B in this chapter.) a. Complete the worksheet for a bull spread below.

Value of British Pound at Option Expiration $1.50

$1.56

$1.59

$1.65

Call @ $1.56 Call @ $1.59 Net

b. What is the break-even point for this bull spread? c. What is the maximum proﬁt of this bull spread?

What is the maximum loss? d. If the British pound spot rate is $1.58 at option

expiration, what is the total proﬁt or loss for the bull spread? e. If the British pound spot rate is $1.55 at option

expiration, what is the total proﬁt or loss for a bear spread? 37. Bull Spreads and Bear Spreads. Two British pound (£) put options are available with exercise prices of $1.60 and $1.62. The premiums associated with these options are $.03 and $.04 per unit, respectively. (See Appendix B in this chapter.)

c. At option expiration, the spot rate of the pound is $1.60. What is the bull spreader’s total gain or loss? d. At option expiration, the spot rate of the pound is $1.58. What is the bear spreader’s total gain or loss?

38. Proﬁts from Using Currency Options and Futures. On July 2, the 2-month futures rate of the Mexican peso contained a 2 percent discount (unannualized). There was a call option on pesos with an exercise price that was equal to the spot rate. There was also a put option on pesos with an exercise price equal to the spot rate. The premium on each of these options was 3 percent of the spot rate at that time. On September 2, the option expired. Go to http://www.oanda.com (or any website that has foreign exchange rate quotations) and determine the direct quote of the Mexican peso. You exercised the option on this date if it was feasible to do so. a. What was your net proﬁt per unit if you had purchased the call option? b. What was your net proﬁt per unit if you had purchased the put option? c. What was your net proﬁt per unit if you had purchased a futures contract on July 2 that had a settlement date of September 2? d. What was your net proﬁt per unit if you sold a futures contract on July 2 that had a settlement date of September 2?

Discussion in the Boardroom This exercise can be found in Appendix E at the back of this textbook. Running Your Own MNC This exercise can be found on the Xtra! website at http://maduraxtra.swlearning.com.

Chapter 5: Currency Derivatives

BLADES,

INC.

133

CASE

Use of Currency Derivative Instruments Blades, Inc., needs to order supplies 2 months ahead of the delivery date. It is considering an order from a Japanese supplier that requires a payment of 12.5 million yen payable as of the delivery date. Blades has two choices:

The table below summarizes the option and futures information available to Blades: Before Event

• Purchase two call options contracts (since each option contract represents 6,250,000 yen).

Spot rate

• Purchase one futures contract (which represents 12.5 million yen).

Option Information

The futures price on yen has historically exhibited a slight discount from the existing spot rate. However, the ﬁrm would like to use currency options to hedge payables in Japanese yen for transactions 2 months in advance. Blades would prefer hedging its yen payable position because it is uncomfortable leaving the position open given the historical volatility of the yen. Nevertheless, the ﬁrm would be willing to remain unhedged if the yen becomes more stable someday. Ben Holt, Blades’ chief ﬁnancial ofﬁcer (CFO), prefers the ﬂexibility that options offer over forward contracts or futures contracts because he can let the options expire if the yen depreciates. He would like to use an exercise price that is about 5 percent above the existing spot rate to ensure that Blades will have to pay no more than 5 percent above the existing spot rate for a transaction 2 months beyond its order date, as long as the option premium is no more than 1.6 percent of the price it would have to pay per unit when exercising the option. In general, options on the yen have required a premium of about 1.5 percent of the total transaction amount that would be paid if the option is exercised. For example, recently the yen spot rate was $.0072, and the ﬁrm purchased a call option with an exercise price of $.00756, which is 5 percent above the existing spot rate. The premium for this option was $.0001134, which is 1.5 percent of the price to be paid per yen if the option is exercised. A recent event caused more uncertainty about the yen’s future value, although it did not affect the spot rate or the forward or futures rate of the yen. Speciﬁcally, the yen’s spot rate was still $.0072, but the option premium for a call option with an exercise price of $.00756 was now $.0001512. An alternative call option is available with an expiration date of 2 months from now; it has a premium of $.0001134 (which is the size of the premium that would have existed for the option desired before the event), but it is for a call option with an exercise price of $.00792.

After Event

$.0072

$.0072

$.0072

$.00756

$.00756

$.00792

Exercise price (% above spot)

5%

5%

10%

Option premium per yen ($)

$.0001134

$.0001512

$.0001134

1.5%

2.0%

1.5%

Total premium ($)

$1,417.50

$1,890.00

$1,417.50

Amount paid for yen if option is exercised (not including premium)

$94,500

$94,500

$99,000

Exercise price ($)

Option premium (% of exercise price)

Futures Contract Information Futures price

$.006912

$.006912

As an analyst for Blades, you have been asked to offer insight on how to hedge. Use a spreadsheet to support your analysis of questions 4 and 6. 1. If Blades uses call options to hedge its yen payables, should it use the call option with the exercise price of $.00756 or the call option with the exercise price of $.00792? Describe the tradeoff. 2. Should Blades allow its yen position to be unhedged? Describe the tradeoff. 3. Assume there are speculators who attempt to capitalize on their expectation of the yen’s movement over the 2 months between the order and delivery dates by either buying or selling yen futures now and buying or selling yen at the future spot rate. Given this information, what is the expectation on the order date of the yen spot rate by the delivery date? (Your answer should consist of one number.) 4. Assume that the ﬁrm shares the market consensus of the future yen spot rate. Given this expectation and given that the ﬁrm makes a decision (i.e.,

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option, futures contract, remain unhedged) purely on a cost basis, what would be its optimal choice? 5. Will the choice you made as to the optimal hedging strategy in question 4 deﬁnitely turn out to be the lowest-cost alternative in terms of actual costs incurred? Why or why not? 6. Now assume that you have determined that the historical standard deviation of the yen is about

SMALL

BUSINESS

$.0005. Based on your assessment, you believe it is highly unlikely that the future spot rate will be more than two standard deviations above the expected spot rate by the delivery date. Also assume that the futures price remains at its current level of $.006912. Based on this expectation of the future spot rate, what is the optimal hedge for the ﬁrm?

DILEMMA

Use of Currency Futures and Options by the Sports Exports Company The Sports Exports Company receives British pounds each month as payment for the footballs that it exports. It anticipates that the pound will depreciate over time against the U.S. dollar. 1. How can the Sports Exports Company use currency futures contracts to hedge against exchange rate risk? Are there any limitations of using currency futures contracts that would prevent the Sports Exports Company from locking in a speciﬁc exchange rate at which it can sell all the pounds it expects to receive in each of the upcoming months? 2. How can the Sports Exports Company use currency options to hedge against exchange rate risk?

I N T E R N E T/ E XC E L The website of the Chicago Mercantile Exchange provides information about currency futures and options. Its address is http://www.cme.com. 1. Use this website to review the prevailing prices of currency futures contracts. Do today’s futures prices (for contracts with the closest settlement date) generally reﬂect an increase or decrease from the day before? Is there any news today that might explain the change in the futures prices? 2. Does it appear that futures prices among currencies (for the closest settlement date) are changing in the same direction? Explain.

Are there any limitations of using currency options contracts that would prevent the Sports Exports Company from locking in a speciﬁc exchange rate at which it can sell all the pounds it expects to receive in each of the upcoming months? 3. Jim Logan, owner of the Sports Exports Company, is concerned that the pound may depreciate substantially over the next month, but he also believes that the pound could appreciate substantially if speciﬁc situations occur. Should Jim use currency futures or currency options to hedge the exchange rate risk? Is there any disadvantage of selecting this method for hedging?

EXERCISES 3. If you purchase a British pound futures contract with the closest settlement date, what is the futures price? Given that a contract is based on 62,500 pounds, what is the dollar amount you will need at the settlement date to fulﬁ ll the contract? 4. Go to http://www.phlx.com/products and obtain the money currency option quotations for the Canadian dollar (the symbol is XCD) and the euro (symbol is XEU) for a similar expiration date. Which currency option has a larger premium? Explain your results.

APPENDIX 5A Currency Option Pricing

The premiums paid for currency options depend on various factors that must be monitored when anticipating future movements in currency option premiums. Since participants in the currency options market typically take positions based on their expectations of how the premiums will change over time, they can beneﬁt from understanding how options are priced.

Boundary Conditions The ﬁrst step in pricing currency options is to recognize boundary conditions that force the option premium to be within lower and upper bounds.

Lower Bounds The call option premium (C) has a lower bound of at least zero or the spread between the underlying spot exchange rate (S) and the exercise price (X), whichever is greater, as shown below: C MAX(0, S X) This ﬂoor is enforced by arbitrage restrictions. For example, assume that the premium on a British pound call option is $.01, while the spot rate of the pound is $1.62 and the exercise price is $1.60. In this example, the spread (S X) exceeds the call premium, which would allow for arbitrage. One could purchase the call option for $.01 per unit, immediately exercise the option at $1.60 per pound, and then sell the pounds in the spot market for $1.62 per unit. This would generate an immediate proﬁt of $.01 per unit. Arbitrage would continue until the market forces realigned the spread (S X) to be less than or equal to the call premium. The put option premium (P) has a lower bound of zero or the spread between the exercise price (X) and the underlying spot exchange rate (S), whichever is greater, as shown below: P MAX(0, X S) This ﬂoor is also enforced by arbitrage restrictions. For example, assume that the premium on a British pound put option is $.02, while the spot rate of the pound is $1.60 and the exercise price is $1.63. One could purchase the pound put option for $.02 per unit, purchase pounds in the spot market at $1.60, and immediately exercise the option by selling the pounds at $1.63 per unit. This would generate an immediate proﬁt of $.01 per unit. Arbitrage would continue until the market forces realigned the spread (X S) to be less than or equal to the put premium.

135

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Part 1: The International Financial Environment

APPENDIX 5A

Upper Bounds The upper bound for a call option premium is equal to the spot exchange rate (S): CS If the call option premium ever exceeds the spot exchange rate, one could engage in arbitrage by selling call options for a higher price per unit than the cost of purchasing the underlying currency. Even if those call options are exercised, one could provide the currency that was purchased earlier (the call option was covered). The arbitrage proﬁt in this example is the difference between the amount received when selling the premium and the cost of purchasing the currency in the spot market. Arbitrage would occur until the call option’s premium was less than or equal to the spot rate. The upper bound for a put option is equal to the option’s exercise price (X): PX If the put option premium ever exceeds the exercise price, one could engage in arbitrage by selling put options. Even if the put options are exercised, the proceeds received from selling the put options exceed the price paid (which is the exercise price) at the time of exercise. Given these boundaries that are enforced by arbitrage, option premiums lie within these boundaries.

Application of Pricing Models H T T P : // http://www.ozforex.com.au/ cgi-bin/optionscalc.asp Estimates the price of currency options based on input provided.

Although boundary conditions can be used to determine the possible range for a currency option’s premium, they do not precisely indicate the appropriate premium for the option. However, pricing models have been developed to price currency options. Based on information about an option (such as the exercise price and time to maturity) and about the currency (such as its spot rate, standard deviation, and interest rate), pricing models can derive the premium on a currency option. The currency option pricing model of Biger and Hull1 is shown below: C 5 e2r*TS ? N 1 d1 2 2 e2rTX ? N 1 d1 2 s"T 2 where

d1 {ln(S/X) [r r* (s2/2)]T}/s !T C price of the currency call option S underlying spot exchange rate X exercise price r U.S. riskless rate of interest r* foreign riskless rate of interest s instantaneous standard deviation of the return on a holding of foreign currency T option’s time maturity expressed as a fraction of a year N() standard normal cumulative distribution function

This equation is based on the stock option pricing model (OPM) when allowing for continuous dividends. Since the interest gained on holding a foreign security (r*) is equivalent to a continuously paid dividend on a stock share, this version of the OPM holds completely. The key transformation in adapting the stock OPM to value currency options is the substitution of exchange rates for stock prices. Thus,

1

Nahum Biger and John Hull, “The Valuation of Currency Options,” Financial Management (Spring 1983), 24–28.

Chapter 5: Currency Derivatives

137

Pricing Currency Put Options According to Put-Call Parity Given the premium of a European call option (called C), the premium for a European put option (called P) on the same currency and same exercise price (X) can be derived from put-call parity, as shown below: P C Xert Ser*T where r U.S. riskless rate of interest r* foreign riskless rate of interest T option’s time to maturity expressed as a fraction of the year If the actual put option premium is less than what is suggested by the put-call parity equation above, arbitrage can be conducted. Speciﬁcally, one could (1) buy the put option, (2) sell the call option, and (3) buy the underlying currency. The purchases are ﬁnanced with the proceeds from selling the call option and from borrowing at the rate r. Meanwhile, the foreign currency that was purchased can be deposited to earn the foreign rate r*. Regardless of the scenario for the path of the currency’s exchange rate movement over the life of the option, the arbitrage will result in a proﬁt. First, if the exchange rate is equal to the exercise price such that each option expires worthless, the foreign currency can be converted in the spot market to dollars, and this amount will exceed the amount required to repay the loan. Second, if the foreign currency appreciates and therefore exceeds the exercise price, there will be a loss from the call option being exercised. Although the put option will expire, the foreign currency will be converted in the spot market to dollars, and this amount will exceed the amount 2 James Bodurtha and Georges Courtadon, “Tests of an American Option Pricing Model on the Foreign Currency Options Market,” Journal of Financial and Quantitative Analysis (June 1987): 153–168.

APPENDIX 5A

the percentage change of exchange rates is assumed to follow a diffusion process with constant mean and variance. Bodurtha and Courtadon 2 have tested the predictive ability of the currency option pricing model. They computed pricing errors from the model using 3,326 call options. The model’s average percentage pricing error for call options was 6.90 percent, which is smaller than the corresponding error reported for the dividend-adjusted Black-Scholes stock OPM. Hence, the currency option pricing model has been more accurate than the counterpart stock OPM. The model developed by Biger and Hull is sometimes referred to as the European model because it does not account for early exercise. European currency options do not allow for early exercise (before the expiration date), while American currency options do allow for early exercise. The extra ﬂexibility of American currency options may justify a higher premium on American currency options than on European currency options with similar characteristics. However, there is not a closed-form model for pricing American currency options. Although various techniques are used to price American currency options, the European model is commonly applied to price American currency options because it can be just as accurate. Bodurtha and Courtadon found that the application of an American currency options pricing model does not improve predictive accuracy. Their average percentage pricing error was 7.07 percent for all sample call options when using the American model. Given all other parameters, the currency option pricing model can be used to impute the standard deviation s. This implied parameter represents the option’s market assessment of currency volatility over the life of the option.

APPENDIX 5A

138

Part 1: The International Financial Environment

required to repay the loan and the amount of the loss on the call option. Third, if the foreign currency depreciates and therefore is below the exercise price, the amount received from exercising the put option plus the amount received from converting the foreign currency to dollars will exceed the amount required to repay the loan. Since the arbitrage generates a proﬁt under any exchange rate scenario, it will force an adjustment in the option premiums so that put-call parity is no longer violated. If the actual put option premium is more than what is suggested by put-call parity, arbitrage would again be possible. The arbitrage strategy would be the reverse of that used when the actual put option premium was less than what is suggested by put-call parity (as just described). The arbitrage would force an adjustment in option premiums so that put-call parity is no longer violated. The arbitrage that can be applied when there is a violation of put-call parity on American currency options differs slightly from the arbitrage applicable to European currency options. Nevertheless, the concept still holds that the premium of a currency put option can be determined according to the premium of a call option on the same currency and the same exercise price.

APPENDIX 5B Currency Option Combinations

In addition to the basic call and put options just discussed, a variety of currency option combinations are available to the currency speculator and hedger. A currency option combination uses simultaneous call and put option positions to construct a unique position to suit the hedger’s or speculator’s needs. A currency option combination may include both long and short positions and will itself be either long or short. Typically, a currency option combination will result in a unique contingency graph. Currency option combinations can be used both to hedge cash inﬂows and outﬂows denominated in a foreign currency and to speculate on the future movement of a foreign currency. More speciﬁcally, both MNCs and individual speculators can construct a currency option combination to accommodate expectations of either appreciating or depreciating foreign currencies. In this appendix, two of the most popular currency option combinations are discussed. These are straddles and strangles. For each of these combinations, the following topics will be discussed: • The composition of the combination • The worksheet and contingency graph for the long combination • The worksheet and contingency graph for the short combination • Uses of the combination to speculate on the movement of a foreign currency The two main types of currency option combinations are discussed next.

Currency Straddles

Getty Images

Long Currency Straddle To construct a long straddle in a foreign currency, an MNC or individual would buy (take a long position in) both a call option and a put option for that currency; the call and the put option have the same expiration date and striking price. When constructing a long straddle, the buyer purchases both the right to buy the foreign currency and the right to sell the foreign currency. Since the call option will become proﬁtable if the foreign currency appreciates, and the put option will become proﬁtable if the foreign currency depreciates, a long straddle becomes proﬁtable when the foreign currency either appreciates or depreciates. Obviously, this is a huge advantage for the individual or entity that constructs a long straddle, since it appears that it would beneﬁt from the position as long as the foreign currency exchange rate does not remain constant. The disadvantage of a long straddle position is that it is expensive to construct, because it involves the purchase of two separate options, each of

139

APPENDIX 5B

140

Part 1: The International Financial Environment

which requires payment of the option premium. Therefore, a long straddle becomes proﬁtable only if the foreign currency appreciates or depreciates substantially.

Long Currency Straddle Worksheet. To determine the proﬁt or loss associated with a long straddle (or any combination), it is easiest to ﬁrst construct a proﬁt or loss worksheet for several possible currency values at option expiration. The worksheet can be set up to show each individual option position and the net position. The worksheet will also help in constructing a contingency graph for the combination. E X A M P L E

Put and call options are available for euros (€) with the following information:

• Call option premium on euro $.03 per unit. • Put option premium on euro $.02 per unit. • Strike price $1.05. • One option contract represents €62,500. To construct a long straddle, the buyer would purchase both a euro call and a euro put option, paying $.03 $.02 $.05 per unit. If the value of the euro at option expiration is above the strike price of $1.05, the call option is in the money, but the put option is out of the money. Conversely, if the value of the euro at option expiration is below $1.05, the put option is in the money, but the call option is out of the money. A possible worksheet for the long straddle that illustrates the proﬁtability of the individual components is shown below:

Value of Euro at Option Expiration $.95

$1.00

$1.05

$1.10

$1.15

$1.20

Own a call

$.03

$.03

$.03

$.02

$.07

$.12

Own a put

$.08

$.03

$.02

$.02

$.02

$.02

Net

$.05

$.00

$.05

$.00

$.05

$.10

Long Currency Straddle Contingency Graph. A contingency graph for the long currency straddle is shown in Exhibit 5B.1. This graph includes more extreme possible outcomes than are shown in the table. Either the call or put option on the foreign currency will be in the money at option expiration as long as the foreign currency value at option expiration differs from the strike price. There are two break-even points for a long straddle position—one below the strike price and one above the strike price. The lower break-even point is equal to the strike price less both premiums; the higher break-even point is equal to the strike price plus both premiums. Thus, for the above example, the two break-even points are located at $1.00 $1.05 $.05 and at $1.10 $1.05 $.05. The maximum loss for the long straddle in the example occurs at a euro value at option expiration equal to the strike price, when both options are at the money. At that point, the straddle buyer would lose both option premiums. The maximum loss for the straddle buyer is thus equal to $.05 $.03 $.02.

Short Currency Straddle Constructing a short straddle in a foreign currency involves selling (taking a short position in) both a call option and a put option for that currency. As in a long straddle, the call and put option have the same expiration date and strike price.

■

Chapter 5: Currency Derivatives

141 APPENDIX 5B

Exhibit 5B.1 Contingency Graph for a Long Currency Straddle

Net Proﬁt per Unit

$1.00

$1.00

$1.10 $1.05

$.05

Future Spot Rate

The advantage of a short straddle is that it provides the option writer with income from two separate options. The disadvantage is the possibility of substantial losses if the underlying currency moves substantially away from the strike price.

Short Currency Straddle Worksheet and Contingency Graph. A short straddle results in a worksheet and contingency graph that are exactly opposite to those of a long straddle. Assuming the same information as in the previous example, a short straddle would involve writing both a call option on euros and a put option on euros. A possible worksheet for the resulting short straddle is shown below:

E X A M P L E

Value of Euro at Option Expiration $.95

$1.00

$1.05

$1.10

$1.15

$1.20

Sell a call

$.03

$.03

$.03

$.02

$.07

$.12

Sell a put

$.08

$.03

$.02

$.02

$.02

$.02

Net

$.05

$.00

$.05

$.00

$.05

$.10

The worksheet also illustrates that there are two break-even points for a short straddle position—one below the strike price and one above the strike price. The lower break-even point is equal to the strike price less both premiums; the higher break-even point is equal to the strike price plus both premiums. Thus, the two break-even points are located at $1.00 $1.05 $.05 and at $1.10 $1.05 $.05. This is the same relationship as for the long straddle position. The maximum gain occurs at a euro value at option expiration equal to the strike price of $1.05 and is equal to the sum of the two option premiums ($.03 $.02 $.05). The resulting contingency graph is shown in Exhibit 5B.2. ■

Part 1: The International Financial Environment Exhibit 5B.2 Contingency Graph for a Short Currency Straddle

$.05

Net Proﬁt per Unit

APPENDIX 5B

142

$1.10

$1.00

$1.05

$1.00

Future Spot Rate

Speculating with Currency Straddles Individuals can speculate using currency straddles based on their expectations of the future movement in a particular foreign currency. For example, speculators who expect that the British pound will appreciate or depreciate substantially can buy a straddle. If the pound appreciates substantially, the speculator will let the put option expire and exercise the call option. If the pound depreciates substantially, the speculator will let the call option expire and exercise the put option. Speculators may also proﬁt from short straddles. The writer of a short straddle believes that the value of the underlying currency will remain close to the exercise price until option expiration. If the value of the underlying currency is equal to the strike price at option expiration, the straddle writer would collect premiums from both options. However, this is a rather risky position; if the currency appreciates or depreciates substantially, the straddle writer will lose money. If the currency appreciates substantially, the straddle writer will have to sell the currency for the strike price, since the call option will be exercised. If the currency depreciates substantially, the straddle writer has to buy the currency for the strike price, since the put option will be exercised.

E X A M P L E

Call and put option contracts on British pounds (£) are available with the following information:

• Call option premium on British pounds $.035. • Put option premium on British pounds $.025. • Strike price $1.50. • One option contract represents £31,250. At expiration, the spot rate of the pound is $1.40. A speculator who had bought a straddle will therefore exercise the put option but let the call option expire. Therefore, the speculator will

Chapter 5: Currency Derivatives

143

Per Unit

Per Contract

Selling price of £

$1.50

$46,875 ($1.50 31,250 units)

Purchase price of £

1.40

43,750 ($1.40 31,250 units)

Premium paid for call option

.035

1,093.75 ($.035 31,250 units)

Premium paid for put option

.025

781.25 ($.025 31,250 units)

Net proﬁt

$.04

$1,250 ($.04 31,250 units)

The straddle writer will have to purchase pounds for the exercise price. Assuming the speculator immediately sells the acquired pounds at the prevailing spot rate, the net proﬁt to the straddle writer will be: Per Unit

Per Contract

Selling price of £

$1.40

$43,750 ($1.40 31,250 units)

Purchase price of £

1.50

46,875 ($1.50 31,250 units)

Premium received for call option

.035

1,093.75 ($.035 31,250 units)

Premium received for put option

.025

781.25 ($.025 31,250 units)

Net proﬁt

$.04

$1,250 ($.04 31,250 units)

As with an individual short put position, the seller of the straddle could simply refrain from selling the pounds (after being forced to buy them at the exercise price of $1.50) until the spot rate of the pound rises. However, there is no guarantee that the pound will appreciate in the near future. ■

Note from the above example and discussion that the straddle writer gains what the straddle buyer loses, and vice versa. Consequently, the straddle writer’s gain or loss is the straddle buyer’s loss or gain. Thus, the same relationship that applies to individual call and put options also applies to option combinations.

Currency Strangles Currency strangles are very similar to currency straddles, with one important difference: The call and put options of the underlying foreign currency have different exercise prices. Nevertheless, the underlying security and the expiration date for the call and put options are identical.

Long Currency Strangle Since the call and put options used in a strangle can have different exercise prices, a long strangle can be constructed in a variety of ways. For example, a strangle could be constructed in which the call option has a higher exercise price than the put option and vice versa. The most common type of strangle, and the focus of this section, is a strangle that involves buying a put option with a lower strike price than the call option that is purchased. To construct a long strangle in a foreign currency, an MNC or individual would thus take a long position in a call option and a long position in a put option for that currency. The call option has the higher exercise price.

APPENDIX 5B

buy pounds at the prevailing spot rate and sell them for the exercise price. Given this information, the net proﬁt to the straddle buyer is calculated as follows:

APPENDIX 5B

144

Part 1: The International Financial Environment

An advantage of a long strangle relative to a comparable long straddle is that it is cheaper to construct. From previous sections, recall that there is an inverse relationship between the spot price of the currency relative to the strike price and the call option premium: the lower the spot price relative to the strike price, the lower the option premium will be. Therefore, if a long strangle involves purchasing a call option with a relatively high exercise price, it should be cheaper to construct than a comparable straddle, everything else being equal. The disadvantage of a strangle relative to a straddle is that the underlying currency has to ﬂuctuate more prior to expiration. As with a long straddle, the reason for constructing a long strangle is the expectation of a substantial currency ﬂuctuation in either direction prior to the expiration date. However, since the two options involved in a strangle have different exercise prices, the underlying currency has to ﬂuctuate to a larger extent before the strangle is in the money at future spot prices.

Long Currency Strangle Worksheet. The worksheet for a long currency strangle is similar to the worksheet for a long currency straddle, as the following example shows.

E X A M P L E

Put and call options are available for euros (€) with the following information:

• Call option premium on euro $.025 per unit. • Put option premium on euro $.02 per unit. • Call option strike price $1.15. • Put option strike price $1.05. • One option contract represents €62,500. Note that this example is almost identical to the earlier straddle example, except that the call option has a higher exercise price than the put option and the call option premium is slightly lower. A possible worksheet for the long strangle is shown here: Value of Euro at Option Expiration $.95

$1.00

$1.05

$1.10

$1.15

$1.20

Own a call

$.025

$.025

$.025

$.025

$.025

$.025

Own a put

$.08

$.03

$.02

$.02

$.02

$.02

Net

$.055

$.005

$.045

$.045

$.045

$.005

Long Currency Strangle Contingency Graph. Exhibit 5B.3 shows a contingency graph for the long currency strangle. Again, the graph includes more extreme values than are shown in the worksheet. The call option will be in the money when the foreign currency value is higher than its strike price at option expiration, and the put option will be in the money when the foreign currency value is below the put option strike price at option expiration. Thus, the long call position is in the money at euro values above the $1.15 call option exercise price at option expiration. Conversely, the put option is in the money at euro values below the put option exercise price of $1.05. The two break-even points for a long strangle position are located below the put option premium and above the call option premium. The lower break-even point is equal to the put option strike price less both premiums ($1.005 $1.05 $.045); the higher break-even point is equal to the call option strike price plus both premiums ($1.195 $1.15 $.045).

■

Chapter 5: Currency Derivatives

145 APPENDIX 5B

Exhibit 5B.3 Contingency Graph for a Long Currency Strangle

Net Proﬁt per Unit

$1.005

$1.195

$1.005 $1.05

$1.15

$.045

Future Spot Rate

The maximum loss for a long strangle occurs at euro values at option expiration between the two strike prices. At any future spot price between the two exercise prices, the straddle buyer would lose both option premiums ($.045 $.25 $.02). The contingency graph for the long strangle illustrates that the euro must ﬂuctuate more widely than with a straddle before the position becomes proﬁtable. However, the maximum loss is only $.045 per unit, whereas it was $.05 per unit for the long straddle.

Short Currency Strangle Analogous to a short currency straddle, a short strangle involves taking a short position in both a call option and a put option for that currency. As with a short straddle, the call and put options have the same expiration date. However, the call option has the higher exercise price in a short strangle. Relative to a short straddle, the disadvantage of a short strangle is that it provides less income, since the call option premium will be lower, everything else being equal. However, the advantage of a short strangle relative to a short straddle is that the underlying currency has to ﬂuctuate more before the strangle writer is in danger of losing money.

Short Currency Strangle Worksheet and Contingency Graph. The euro example is next used to show that the worksheet and contingency graph for the short strangle are exactly opposite to those of a long strangle. Continuing with the information in the preceding example, a short strangle can be constructed by writing a call option on euros and a put option on euros. The resulting worksheet is shown below:

E X A M P L E

Value of Euro at Option Expiration $.95

$1.00

$1.05

$1.10

$1.15

$1.20

Sell a call

$.025

$.025

$.025

$.025

$.025

$.025

Sell a put

$.08

$.03

$.02

$.02

$.02

$.02

Net

$.055

$.005

$.045

$.045

$.045

$.005

Part 1: The International Financial Environment The table shows that there are two break-even points for the short strangle. The lower breakeven point is equal to the put option strike price less both premiums; the higher break-even point is equal to the call option strike price plus both premiums. The two break-even points are thus located at $1.005 $1.05 $.045 and at $1.195 $1.15 $.045. These break-even points are identical to the break-even points for the long strangle position. The maximum gain for a short strangle ($.045 $.025 $.02) occurs at a value of the euro at option expiration between the two exercise prices. The short strangle contingency graph is shown in Exhibit 5B.4. ■

Speculating with Currency Strangles As with straddles, individuals can speculate using currency strangles based on their expectations of the future movement in a particular foreign currency. For instance, speculators who expect that the Swiss franc will appreciate or depreciate substantially can construct a long strangle. Speculators can beneﬁt from short strangles if the future spot price of the underlying currency is between the two exercise prices. Compared to a straddle, the speculator who buys a strangle believes that the underlying currency will ﬂuctuate even more widely prior to expiration. In return, the speculator pays less to construct the long strangle. A speculator who writes a strangle will receive both option premiums as long as the future spot price is between the two exercise prices. Compared to a straddle, the total amount received from writing the two options is less. However, the range of future spot prices between which no option is exercised is much wider for a short strangle. Call and put option contracts on British pounds (£) are available with the following information:

E E X X A A M M P P L L E

• Call option premium on British pounds $.030. • Put option premium on British pounds $.025. • Call option strike price $1.60. • Put option strike price $1.50. • One option contract represents £31,250.

Exhibit 5B.4

Contingency Graph for a Short Currency Strangle

$.045 $1.005 Net Proﬁt per Unit

APPENDIX 5B

146

$1.195

$1.05

$1.15

$1.005 Future Spot Rate

Chapter 5: Currency Derivatives

147

Per Unit

Per Contract

Premium paid for call option

$.030

$937.50 ($.030 31,250 units)

Premium paid for put option

.025

781.25 ($.025 31,250 units)

$.055

$1,718.75 ($.055 31,250 units)

Net proﬁt

The straddle writer will receive the premiums from both the call and the put option, since neither option will be exercised by its owner: Per Unit

Per Contract

Premium received for call option

$.030

$937.50 ($.030 31,250 units)

Premium received for put option

.025

781.25 ($.025 31,250 units)

$.055

$1,718.75 ($.055 31,250 units)

Net proﬁt

As with individual call or put positions and with a straddle, the strangle writer’s gain or loss is the strangle buyer’s loss or gain. ■

Currency Spreads A variety of currency spreads exist that can be used by both MNCs and individuals to hedge cash inﬂows or outﬂows or to proﬁt from an anticipated movement in a foreign currency. This section covers two of the most popular types of spreads: bull spreads and bear spreads. Bull spreads are proﬁtable when a foreign currency appreciates, whereas bear spreads are proﬁtable when a foreign currency depreciates.

Currency Bull Spreads with Call Options A currency bull spread is constructed by buying a call option for a particular underlying currency and simultaneously writing a call option for the same currency with a higher exercise price. A bull spread can also be constructed using currency put options, as will be discussed shortly. With a bull spread, the spreader believes that the underlying currency will appreciate modestly, but not substantially. Assume two call options on Australian dollars (A$) are currently available. The ﬁrst option has a strike price of $.64 and a premium of $.019. The second option has a strike price of $.65 and a premium of $.015. The bull spreader buys the $.64 option and sells the $.65 option. An option contract on Australian dollars consists of 50,000 units. Consider the following scenarios:

E X A M P L E

1. The Australian dollar appreciates to $.645, a spot price between the two exercise prices. The bull spreader will exercise the option he bought. Assuming the bull spreader immediately sells the Australian dollars for the $.645 spot rate after purchasing them for the $.64 exercise price, he will gain the difference. The bull spreader will also collect the premium on the second option he wrote, but that option will not be exercised by the (unknown) buyer:

APPENDIX 5B

The spot rate of the pound on the expiration date is $1.52. With a long strangle, the speculator will let both options expire, since both the call and the put option are out of the money. Consequently, the strangle buyer will lose both option premiums:

APPENDIX 5B

148

Part 1: The International Financial Environment

Per Unit

Per Contract

Selling price of A$

$.645

$32,250 ($.645 50,000 units)

Purchase price of A$

.64

32,000 ($.64 50,000 units)

Premium paid for call option

.019

950 ($.019 50,000 units)

Premium received for call option

.015

750 ($.015 50,000 units)

Net proﬁt

$.001

$50 ($.001 50,000 units)

Under this scenario, note that the bull spreader would have incurred a net loss of $.645 $.64 $.019 $.014/A$ if he had purchased only the ﬁrst option. By writing the second call option, the spreader increased his net proﬁt by $.015/A$. 2. The Australian dollar appreciates to $.70, a value above the higher exercise price. Under this scenario, the bull spreader will exercise the option he purchased, but the option he wrote will also be exercised by the (unknown) buyer. Assuming the bull spreader immediately sells the Australian dollars purchased with the ﬁrst option and buys the Australian dollars he has to sell to the second option buyer for the spot rate, he will incur the following cash ﬂows: Per Unit

Per Contract

Selling price of A$

$.70

$35,000 ($.70 50,000 units)

Purchase price of A$

.64

32,000 ($.64 50,000 units)

Premium paid for call option

.019

950 ($.019 50,000 units)

Selling price of A$

$.65

32,500 ($.65 50,000 units)

Purchase price of A$

.70

35,000 ($.70 50,000 units)

Premium received for call option

.015

750 ($.015 50,000 units)

Net proﬁt

$.006

$300 ($.006 50,000 units)

The important point to understand here is that the net proﬁt to the bull spreader will remain $.006/A$ no matter how much more the Australian dollar appreciates. This is because the bull spreader will always sell the Australian dollars he purchased with the ﬁrst option for the spot price and purchase the Australian dollars needed to meet his obligation for the second option. The two effects always cancel out, so the bull spreader will net the difference in the two strike prices less the difference in the two premiums ($.65 $.64 $.019 $.015 $.006). Therefore, the net proﬁt to the bull spreader will be $.006 per unit at any future spot price above $.65. Equally important to understand is the tradeoff involved in constructing a bull spread. The bull spreader in effect forgoes the beneﬁt from a large currency appreciation by collecting the premium from writing a currency option with a higher exercise price and ensuring a constant proﬁt at future spot prices above the higher exercise price; if he had not written the second option with the higher exercise price, he would have beneﬁted substantially under this scenario, netting $.70 $.64 $.019 $.041/A$ as a result of exercising the call option with the $.64 strike price. This is the reason the bull spreader expects that the underlying currency will appreciate modestly so that he gains from the option he buys and collects the premium from the option he sells without incurring any opportunity costs. 3. The Australian dollar depreciates to $.62, a value below the lower exercise price. If the future spot price is below the lower exercise price, neither call option will be exercised, as

Chapter 5: Currency Derivatives

149

Premium paid for call option Premium received for call option Net proﬁt

Per Unit

Per Contract

$.019

$950 ($.019 50,000 units)

.015

750 ($.015 50,000 units)

$.004

$200 ($.004 50,000 units)

Similar to the scenario where the Australian dollar appreciates modestly between the two exercise prices, the bull spreader’s loss in this case is reduced by the premium received from writing the call option with the higher exercise price. ■

Currency Bull Spread Worksheet and Contingency Graph. For the Australian dollar example above, a worksheet and contingency graph can be constructed. One possible worksheet is shown below: Value of Australian Dollar at Option Expiration $.60

$.64

Buy a call

$.019

$.019

Sell a call

$.015

Net

$.004

$.645

$.65

$.70

$.014

$.009

$.041

$.015

$.015

$.015

$.035

$.004

$.001

$.006

$.006

Exhibit 5B.5 shows the corresponding contingency graph. The worksheet and contingency graph show that the maximum loss for the bull spreader is limited to the difference between the two option premiums of $.004 $.019 $.015. This maximum loss occurs at future spot prices equal to the lower strike price or below. Exhibit 5B.5 Contingency Graph for a Currency Bull Spread

Net Proﬁt per Unit

$.006 $.644 $.64 $.65

$.004

Future Spot Rate

APPENDIX 5B

they are both out of the money. Consequently, the net proﬁt to the bull spreader is the difference between the two option premiums:

APPENDIX 5B

150

Part 1: The International Financial Environment

Also note that for a bull spread the gain is limited to the difference between the strike prices less the difference in the option premiums and is equal to $.006 $.65 $.64 $.004. This maximum gain occurs at future spot prices equal to the higher exercise price or above. The break-even point for the bull spread is located at the lower exercise price plus the difference in the two option premiums and is equal to $.644 $.64 $.004.

Currency Bull Spreads with Put Options As mentioned previously, currency bull spreads can be constructed just as easily with put options as with call options. To construct a put bull spread, the spreader would again buy a put option with a lower exercise price and write a put option with a higher exercise price. The basic arithmetic involved in constructing a put bull spread is thus essentially the same as for a call bull spread, with one important difference, as discussed next. Recall that there is a positive relationship between the level of the existing spot price relative to the strike price and the call option premium. Consequently, the option with the higher exercise price that is written in a call bull spread will have the lower option premium, everything else being equal. Thus, buying the call option with the lower exercise price and writing the call option with the higher exercise price involves a cash outﬂow for the bull spreader. For this reason, call bull spreads fall into a broader category of spreads called debit spreads. Also recall that the lower the spot rate relative to the strike price, the higher the put option premium will be. Consequently, the option with the higher strike price that is written in a put bull spread will have the higher option premium, everything else being equal. Thus, buying the put option with the lower exercise price and writing the put option with the higher exercise price in a put bull spread results in a cash inﬂow for the bull spreader. For this reason, put bull spreads fall into a broader category of spreads called credit spreads.

Speculating with Currency Bull Spreads The speculator who constructs a currency bull spread trades proﬁt potential for a reduced cost of establishing the position. Ideally, the underlying currency will appreciate to the higher exercise price but not far above it. Although the speculator would still realize the maximum gain of the bull spread in this case, he or she would incur signiﬁcant opportunity costs if the underlying currency appreciates much above the higher exercise price. Speculating with currency bull spreads is appropriate for currencies that are expected to appreciate slightly until the expiration date. Since the bull spread involves both buying and writing options for the underlying currency, bull spreads can be relatively cheap to construct and will not result in large losses if the currency depreciates. Conversely, bull spreads are useful tools to generate additional income for speculators.

Currency Bear Spreads The easiest way to think about a currency bear spread is as a short bull spread. That is, a currency bear spread involves taking exactly the opposite positions involved in a bull spread. The bear spreader writes a call option for a particular underlying currency and simultaneously buys a call option for the same currency with a higher exercise price. Consequently, the bear spreader anticipates a modest depreciation in the foreign currency.

Currency Bear Spread Worksheet and Contingency Graph. For the Australian dollar example above, the bear spreader writes the $.64 option and buys the $.65 option. A worksheet and contingency graph can be constructed. One possible worksheet is shown on the next page:

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$.60

$.64

Sell a call

$.019

$.019

Buy a call

$.015

Net

$.004

$.645

$.65

$.70

$.014

$.009

$.041

$.015

$.015

$.015

$.035

$.004

$.001

$.006

$.006

The corresponding contingency graph is shown in Exhibit 5B.6. Notice that the worksheet and contingency graph for the bear spread are the mirror image of the worksheet and contingency graph for the bull spread. Consequently, the maximum gain for the bear spreader is limited to the difference between the two exercise prices of $.004 $.019 $.015, and the maximum loss for a bear spread ($.006 $.65 $.64 $.004) occurs when the Australian dollar’s value is equal to or above the exercise price at option expiration. Also, the break-even point is located at the lower exercise price plus the difference in the two option premiums and is equal to $.644 $.64 $.004, which is the same break-even point as for the bull spread. It is evident from the above illustration that the bear spreader hopes for a currency depreciation. An alternative way to proﬁt from a depreciation would be to buy a put option for the currency. A bear spread, however, is typically cheaper to construct, since it involves buying one call option and writing another call option. The disadvantage of the bear spread compared to a long put position is that opportunity costs can be signiﬁcant if the currency depreciates dramatically. Consequently, the bear spreader hopes for a modest currency depreciation. Exhibit 5B.6 Contingency Graph for a Currency Bear Spread

$.004 Net Proﬁt per Unit

$.644 $.65 $.64

$.006

Future Spot Rate

APPENDIX 5B

Value of Australian Dollar at Option Expiration

PART 1 INTEGRATIVE PROBLEM

The International Financial Environment

Mesa Co. specializes in the production of small fancy picture frames, which are exported from the United States to the United Kingdom. Mesa invoices the exports in pounds and converts the pounds to dollars when they are received. The British demand for these frames is positively related to economic conditions in the United Kingdom. Assume that British inﬂation and interest rates are similar to the rates in the United States. Mesa believes that the U.S. balance-of-trade deﬁcit from trade between the United States and the United Kingdom will adjust to changing prices between the two countries, while capital ﬂows will adjust to interest rate differentials. Mesa believes that the value of the pound is very sensitive to changing international capital ﬂows and is moderately sensitive to changing international trade ﬂows. Mesa is considering the following information: • The U.K. inﬂation rate is expected to decline, while the U.S. inﬂation rate is expected to rise. • British interest rates are expected to decline, while U.S. interest rates are expected to increase.

Questions 1

Explain how the international trade ﬂows should initially adjust in response to the changes in inﬂation (holding exchange rates constant). Explain how the international capital ﬂows should adjust in response to the changes in interest rates (holding exchange rates constant).

2 Using the information provided, will Mesa expect the pound to appreciate or depreciate in the future? Explain. 3 Mesa believes international capital ﬂows shift in response to changing interest rate differentials. Is there any reason why the changing interest rate differentials in this example will not necessarily cause international capital ﬂows to change signiﬁcantly? Explain. 4 Based on your answer to question 2, how would Mesa’s cash ﬂows be affected by the expected exchange rate movements? Explain. 5 Based on your answer to question 4, should Mesa consider hedging its exchange rate risk? If so, explain how it could hedge using forward contracts, futures contracts, and currency options.

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Part 2: Exchange Rate Behavior Part 2 (Chapters 6 through 8) focuses on critical relationships pertaining to exchange rates. Chapter 6 explains how governments can influence exchange rate movements and how such movements can affect economic conditions. Chapter 7 explores the relationships among foreign currencies. It also explains how the forward exchange rate is influenced by the differential between interest rates of any two countries. Chapter 8 discusses prominent theories regarding the impact of inflation on exchange rates and the impact of interest rate movements on exchange rates.

Relationship Enforced by Locational Arbitrage Existing Spot Exchange Rate

Relationship Enforced by Triangular Arbitrage

Existing Spot Exchange Rate at Other Locations

Existing Cross Exchange Rates of Currencies Relationship Enforced by Covered Interest Arbitrage

Existing Inﬂation Rate Differential

Existing Forward Exchange Rate

Relationship Suggested by Purchasing Power Parity Relationship Suggested by the Fisher Effect Existing Interest Rate Differential

Relationship Suggested by the International Fisher Effect

Future Exchange Rate Movements

6: Government Influence on Exchange Rates As explained in Chapter 4, government policies affect exchange rates. Some government policies are speciﬁcally intended to affect exchange rates. Other policies are intended to affect economic conditions but indirectly inﬂuence exchange rates. Because the performance of an MNC is affected by exchange rates, ﬁnancial managers need to understand how the government inﬂuences exchange rates.

The specific objectives of this chapter are to: ■ describe the exchange rate systems used by various

governments, ■ explain how governments can use direct intervention

to influence exchange rates, ■ explain how governments can use indirect intervention

to influence exchange rates, and ■ explain how government intervention in the foreign

exchange market can affect economic conditions.

Exchange Rate Systems Exchange rate systems can be classiﬁed according to the degree by which exchange rates are controlled by the government. Exchange rate systems normally fall into one of the following categories: • Fixed • Freely ﬂoating • Managed ﬂoat • Pegged Each of these exchange rate systems is discussed in turn.

Fixed Exchange Rate System In a ﬁxed exchange rate system, exchange rates are either held constant or allowed to ﬂuctuate only within very narrow boundaries. A ﬁ xed exchange rate would be beneﬁcial to a country for the following reasons. First, exporters and importers could engage in international trade without concern about exchange rate movements of the currency to which their local currency is linked. Any ﬁ rms that accept the foreign currency as payment would be insulated from the risk that the currency could depreciate over time. In addition, any ﬁ rms that need to obtain that foreign currency in the future would be insulated from the risk of the currency appreciating over time. Another beneﬁt is that ﬁ rms could engage in direct foreign investment, without concern about exchange rate movements of that currency. They would be able to convert their foreign currency earnings into their home currency without concern that the foreign currency denominating their earnings might weaken over time. Thus, the management of an MNC would be much easier. In addition, investors would be able to invest funds in foreign countries, without concern that the foreign currency denominating their investments might weaken over

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time. A country with a stable exchange rate can attract more funds as investments because the investors would not have to worry about the currency weakening over time. Funds are needed in any country to support economic growth. Countries that attract a large amount of capital ﬂows normally have lower interest rates. This can stimulate their economies. If an exchange rate begins to move too much, governments intervene to maintain it within the boundaries. In some situations, a government will devalue or reduce the value of its currency against other currencies. In other situations, it will revalue or increase the value of its currency against other currencies. A central bank’s actions to devalue a currency in a ﬁ xed exchange rate system is referred to as devaluation. The term devaluation is normally used in a different context than depreciation. Devaluation refers to a downward adjustment of the exchange rate by the central bank. Conversely, revalution refers to an upward adjustment of the exchange rate by the central bank. The methods used by governments to alter the value of a currency are discussed later in this chapter.

Bretton Woods Agreement. From 1944 to 1971, exchange rates were typically ﬁ xed according to a system planned at the Bretton Woods conference (held in Bretton Woods, New Hampshire, in 1944) by representatives from various countries. Because this arrangement, known as the Bretton Woods Agreement, lasted from 1944 to 1971, that period is sometimes referred to as the Bretton Woods era. Each currency was valued in terms of gold; for example, the U.S. dollar was valued as 1/35 ounce of gold. Since all currencies were valued in terms of gold, their values with respect to each other were ﬁ xed. Governments intervened in the foreign exchange markets to ensure that exchange rates drifted no more than 1 percent above or below the initially set rates. Smithsonian Agreement. During the Bretton Woods era, the United States often experienced balance-of-trade deﬁcits, an indication that the dollar’s value may have been too strong, since the use of dollars for foreign purchases exceeded the demand by foreign countries for dollar-denominated goods. By 1971, it appeared that some currency values would need to be adjusted to restore a more balanced ﬂ ow of payments between countries. In December 1971, a conference of representatives from various countries concluded with the Smithsonian Agreement, which called for a devaluation of the U.S. dollar by about 8 percent against other currencies. In addition, boundaries for the currency values were expanded to within 2.25 percent above or below the rates initially set by the agreement. Nevertheless, international payments imbalances continued, and as of February 1973, the dollar was again devalued. By March 1973, most governments of the major countries were no longer attempting to maintain their home currency values within the boundaries established by the Smithsonian Agreement.

Advantages of Fixed Exchange Rates to MNCs. In a ﬁ xed exchange rate environment, MNCs may be able to engage in international trade, direct foreign investment, and international ﬁ nance without worrying about the future exchange rate. Consequently, the managerial duties of an MNC are less difﬁcult.

Disadvantages of Fixed Exchange Rates to MNCs. One disadvantage of a ﬁ xed exchange rate system is that there is still risk that the government will alter the value of a speciﬁc currency. Although an MNC is not exposed to continual movements in an exchange rate, it does face the possibility that its government will devalue or revalue its currency.

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A second disadvantage is that from a macro viewpoint, a ﬁ xed exchange rate system may make each country and its MNCs more vulnerable to economic conditions in other countries. Assume that there are only two countries in the world: the United States and the United Kingdom. Also assume a fixed exchange rate system and that these two countries trade frequently with each other. If the United States experiences a much higher inflation rate than the United Kingdom, U.S. consumers should buy more goods from the United Kingdom and British consumers should reduce their imports of U.S. goods (due to the high U.S. prices). This reaction would force U.S. production down and unemployment up. It could also cause higher inflation in the United Kingdom due to the excessive demand for British goods relative to the supply of British goods produced. Thus, the high inflation in the United States could cause high inflation in the United Kingdom. In the mid- and late 1960s, the United States experienced relatively high inflation and was accused of “exporting” that inflation to some European countries. Alternatively, a high unemployment rate in the United States will cause a reduction in U.S. income and a decline in U.S. purchases of British goods. Consequently, productivity in the United Kingdom may decrease and unemployment may rise. In this case, the United States may “export” unemployment to the United Kingdom. ■

E X A M P L E

Freely Floating Exchange Rate System In a freely ﬂoating exchange rate system, exchange rate values are determined by market forces without intervention by governments. Whereas a ﬁ xed exchange rate system allows no ﬂexibility for exchange rate movements, a freely ﬂoating exchange rate system allows complete ﬂexibility. A freely ﬂoating exchange rate adjusts on a continual basis in response to demand and supply conditions for that currency.

Advantages of a Freely Floating Exchange Rate System. One advantage of a freely ﬂoating exchange rate system is that a country is more insulated from the inﬂation of other countries. Continue with the previous example in which there are only two countries, but now assume a freely floating exchange rate system. If the United States experiences a high rate of inflation, the increased U.S. demand for British goods will place upward pressure on the value of the British pound. As a second consequence of the high U.S. inflation, the reduced British demand for U.S. goods will result in a reduced supply of pounds for sale (exchanged for dollars), which will also place upward pressure on the British pound’s value. The pound will appreciate due to these market forces (it was not allowed to appreciate under the fixed rate system). This appreciation will make British goods more expensive for U.S. consumers, even though British producers did not raise their prices. The higher prices will simply be due to the pound’s appreciation; that is, a greater number of U.S. dollars are required to buy the same number of pounds as before. In the United Kingdom, the actual price of the goods as measured in British pounds may be unchanged. Even though U.S. prices have increased, British consumers will continue to purchase U.S. goods because they can exchange their pounds for more U.S. dollars (due to the British pound’s appreciation against the U.S. dollar). ■

E X A M P L E

Another advantage of freely ﬂoating exchange rates is that a country is more insulated from unemployment problems in other countries. Under a floating rate system, the decline in U.S. purchases of British goods will reflect a reduced U.S. demand for British pounds. Such a shift in demand can cause the pound to depreciate against the dollar (under the fixed rate system, the pound would not be

E X A M P L E

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allowed to depreciate). The depreciation of the pound will make British goods look cheap to U.S. consumers, offsetting the possible reduction in demand for these goods resulting from a lower level of U.S. income. As was true with inflation, a sudden change in unemployment will have less influence on a foreign country under a floating rate system than under a fixed rate system. ■

As these examples illustrate, in a freely ﬂoating exchange rate system, problems experienced in one country will not necessarily be contagious. The exchange rate adjustments serve as a form of protection against “exporting” economic problems to other countries. An additional advantage of a freely ﬂoating exchange rate system is that a central bank is not required to constantly maintain exchange rates within speciﬁed boundaries. Therefore, it is not forced to implement an intervention policy that may have an unfavorable effect on the economy just to control exchange rates. Furthermore, governments can implement policies without concern as to whether the policies will maintain the exchange rates within speciﬁed boundaries. Finally, if exchange rates were not allowed to ﬂoat, investors would invest funds in whatever country had the highest interest rate. This would likely cause governments in countries with low interest rates to restrict investors’ funds from leaving the country. Thus, there would be more restrictions on capital ﬂows, and ﬁ nancial market efﬁciency would be reduced.

Disadvantages of a Freely Floating Exchange Rate System. In the previous example, the United Kingdom is somewhat insulated from the problems experienced in the United States due to the freely ﬂoating exchange rate system. Although this is an advantage for the country that is protected (the United Kingdom), it can be a disadvantage for the country that initially experienced the economic problems. If the United States experiences high inflation, the dollar may weaken, thereby insulating the United Kingdom from the inflation, as discussed earlier. From the U.S. perspective, however, a weaker U.S. dollar causes import prices to be higher. This can increase the price of U.S. materials and supplies, which will in turn increase U.S. prices of finished goods. In addition, higher foreign prices (from the U.S. perspective) can force U.S. consumers to purchase domestic products. As U.S. producers recognize that their foreign competition has been reduced due to the weak dollar, they can more easily raise their prices without losing their customers to foreign competition. ■

E X A M P L E

In a similar manner, a freely ﬂoating exchange rate system can adversely affect a country that has high unemployment. If the U.S. unemployment rate is rising, U.S. demand for imports will decrease, putting upward pressure on the value of the dollar. A stronger dollar will then cause U.S. consumers to purchase foreign products rather than U.S. products because the foreign products can be purchased cheaply. Yet, such a reaction can actually be detrimental to the United States during periods of high unemployment. ■

E X X A M P L E

As these examples illustrate, a country’s economic problems can sometimes be compounded by freely ﬂoating exchange rates. Under such a system, MNCs will need to devote substantial resources to measuring and managing exposure to exchange rate ﬂuctuations. Nonetheless, since exchange rate movements can affect economic conditions within a country, most governments want the ﬂexibility to directly or indirectly control their exchange rates when necessary.

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Managed Float Exchange Rate System The exchange rate system that exists today for some currencies lies somewhere between ﬁ xed and freely ﬂoating. It resembles the freely ﬂoating system in that exchange rates are allowed to ﬂuctuate on a daily basis and there are no ofﬁcial boundaries. It is similar to the ﬁ xed rate system in that governments can and sometimes do intervene to prevent their currencies from moving too far in a certain direction. This type of system is known as a managed ﬂoat or “dirty” ﬂoat (as opposed to a “clean” ﬂoat where rates ﬂoat freely without government intervention). The various forms of intervention used by governments to manage exchange rate movements are discussed later in this chapter. At times, the governments of various countries including Brazil, Russia, South Korea, and Venezuela have imposed bands around their currency to limit its degree of movement. Later, however, they removed the bands when they found that they could not maintain the currency’s value within the bands.

Criticism of a Managed Float System. Critics suggest that a managed ﬂoat system allows a government to manipulate exchange rates in a manner that can beneﬁt its own country at the expense of others. For example, a government may attempt to weaken its currency to stimulate a stagnant economy. The increased aggregate demand for products that results from such a policy may reﬂect a decreased aggregate demand for products in other countries, as the weakened currency attracts foreign demand. Although this criticism is valid, it could apply as well to the ﬁ xed exchange rate system, where governments have the power to devalue their currencies.

Pegged Exchange Rate System Some countries use a pegged exchange rate arrangement, in which their home currency’s value is pegged to a foreign currency or to some unit of account. While the home currency’s value is ﬁ xed in terms of the foreign currency (or unit of account) to which it is pegged, it moves in line with that currency against other currencies. Some governments peg their currency’s value to that of a stable currency, such as the dollar, because that forces the value of their currency to be stable. First, this forces their currency’s exchange rate with the dollar to be ﬁ xed. Second, their currency will move against nondollar currencies by the same degree as the dollar. Since the dollar is more stable than most currencies, it will make their currency more stable than most currencies.

Limitations of a Pegged Exchange Rate. While countries with a pegged exchange rate may attract foreign investment because the exchange rate is expected to remain stable, weak economic or political conditions can cause ﬁ rms and investors to question whether the peg will hold. For example, if the country suddenly experiences a recession, it may experience capital outﬂows as some ﬁ rms and investors withdraw funds because they believe there are better investment opportunities in other countries. These transactions result in an exchange of the local currency for dollars and other currencies, which places downward pressure on the local currency’s value. The central bank would need to offset this by intervening in the foreign exchange market (as explained shortly) but might not be able to maintain the peg. If the peg is broken and the exchange rate is dictated by market forces, the local currency’s value could decline immediately by 20 percent or more. If foreign investors fear that a peg may be broken, they quickly sell their investments in that country and convert the proceeds into their home currency. These transactions place more downward pressure on the local currency of that country. Even the local residents may consider selling their local investments and converting

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their funds to dollars or some other currency if they fear that the peg may be broken. They can exchange their currency for dollars to invest in the United States before the peg breaks. They may leave their investment in the United States until after the peg breaks, and their local currency’s value is reduced. Then they can sell their investments in the United States and convert the dollar proceeds back to their currency at a more favorable exchange rate. Their initial actions to convert their money into dollars placed more downward pressure on the local currency. For the reasons explained here, countries have difﬁculty maintaining a pegged exchange rate when they are experiencing major political or economic problems. While a country with a stable exchange rate can attract foreign investment, the investors will move their funds to another country if there are concerns that the peg will break. Thus, a pegged exchange rate system could ultimately create more instability in a country’s economy. Several examples of pegged exchange rate systems follow.

Creation of Europe’s Snake Arrangement. One of the bestknown pegged exchange rate arrangements was established by several European countries in April 1972. Their goal was to maintain their currencies within established limits of each other. This arrangement became known as the snake. The snake was difﬁcult to maintain, however, and market pressure caused some currencies to move outside their established limits. Consequently, some members withdrew from the snake arrangement, and some currencies were realigned.

Creation of the European Monetary System (EMS). Due to continued problems with the snake arrangement, the European Monetary System (EMS) was pushed into operation in March 1979. The EMS concept was similar to the snake, but the speciﬁc characteristics differed. Under the EMS, exchange rates of member countries were held together within speciﬁed limits and were also tied to the European Currency Unit (ECU), which was a unit of account. Its value was a weighted average of exchange rates of the member countries; each weight was determined by a member’s relative gross national product and activity in intra-European trade. The currencies of these member countries were allowed to ﬂuctuate by no more than 2.25 percent (6 percent for some currencies) from the initially established values. The method of linking European currency values with the ECU was known as the exchange rate mechanism (ERM). The participating governments intervened in the foreign exchange markets to maintain the exchange rates within boundaries established by the ERM.

Demise of the European Monetary System. In the fall of

H T T P : // http://europa.eu.int/ index_en.htm Access to the server of the European Union’s Parliament, Council, Commission, Court of Justice, and other bodies; includes basic information on all related political and economic issues.

1992, however, the exchange rate mechanism experienced severe problems, as economic conditions and goals began to vary among European countries. The German government was mostly concerned about inﬂation because its economy was relatively strong. It increased local interest rates to prevent excessive spending and inﬂation. Other European governments, however, were more concerned about stimulating their economies to lower their high unemployment levels, so they wanted to reduce interest rates. In October 1992, the British and Italian governments suspended their participation in the ERM because they could not achieve their own goals for a stronger economy while their interest rates were so highly inﬂuenced by German interest rates. In 1993, the ERM boundaries were widened substantially, allowing more ﬂuctuation in exchange rates between European currencies. The demise of the exchange rate mechanism caused European countries to realize that a pegged system would work in Europe only if it was set permanently. This provided momentum for the single European currency (the euro), which began in 1999 and is discussed later in this chapter.

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How Mexico’s Pegged System Led to the Mexican Peso Crisis. In 1994, Mexico’s central bank used a special pegged exchange rate system that linked the peso to the U.S. dollar but allowed the peso’s value to ﬂuctuate against the dollar within a band. The Mexican central bank enforced the link through frequent intervention. In fact, it partially supported its intervention by issuing shortterm debt securities denominated in dollars and using the dollars to purchase pesos in the foreign exchange market. Limiting the depreciation of the peso was intended to reduce inﬂationary pressure that can be caused by a very weak home currency. Mexico experienced a large balance-of-trade deﬁcit in 1994, however, perhaps because the peso was stronger than it should have been and encouraged Mexican ﬁ rms and consumers to buy an excessive amount of imports. Many speculators based in Mexico recognized that the peso was being maintained at an artiﬁcially high level, and they speculated on its potential decline by investing their funds in the United States. They planned to liquidate their U.S. investments if and when the peso’s value weakened so that they could convert the dollars from their U.S. investments into pesos at a favorable exchange rate. Ironically, the ﬂow of funds from Mexico to the United States that was motivated by the potential devaluation in the peso put even more downward pressure on the peso because the speculators were converting pesos into dollars to invest in the United States. By December 1994, there was substantial downward pressure on the peso. On December 20, 1994, Mexico’s central bank devalued the peso by about 13 percent. Mexico’s stock prices plummeted, as many foreign investors sold their shares and withdrew their funds from Mexico in anticipation of further devaluation of the peso. On December 22, the central bank allowed the peso to ﬂoat freely, and it declined by 15 percent. This was the beginning of the so-called Mexican peso crisis. In an attempt to discourage foreign investors from withdrawing their investments in Mexico’s debt securities, the central bank increased interest rates, but the higher rates increased the cost of borrowing for Mexican ﬁ rms and consumers, thereby slowing economic growth. As Mexico’s short-term debt obligations denominated in dollars matured, the Mexican central bank used its weak pesos to obtain dollars and repay the debt. Since the peso had weakened, the effective cost of ﬁ nancing with dollars was very expensive for the central bank. Mexico’s ﬁ nancial problems caused investors to lose conﬁdence in peso-denominated securities, so they liquidated their peso-denominated securities and transferred their funds to other countries. These actions put additional downward pressure on the peso. In the 4 months after December 20, 1994, the value of the peso declined by more than 50 percent. Over time, Mexico’s economy improved, and the paranoia that had led to the withdrawal of funds by foreign investors subsided. The Mexican crisis might not have occurred if the peso had been allowed to ﬂoat throughout 1994 because the peso would have gravitated toward its natural level. The crisis illustrates that central bank intervention will not necessarily be able to overwhelm market forces; thus, the crisis may serve as an argument for letting a currency ﬂoat freely.

The Break in China’s Pegged Exchange Rate. From 1996 until 2005, China’s yuan was pegged to be worth about $.12 (8.28 yuan per U.S. dollar). During this period, the yuan’s value would change against nondollar currencies on a daily basis to the same degree as the dollar. Because of the peg, the yuan’s value remained at that level even though the United States was experiencing a trade deﬁcit of more than $100 billion per year with China. U.S. politicians argued that the yuan was being held at a superﬁcially low level by the Chinese government, and if it was allowed to ﬂoat, its value would rise by 10 to 20 percent. The politicians were being pressured by U.S. ﬁ rms that lost business to Chinese exporters. In 2005, some

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politicians argued that an explicit tariff (tax) of about 30 percent should be imposed on all products imported from China. In response to the growing criticism, China revalued its yuan by 2.1 percent in July 2005. It also agreed to allow its yuan to ﬂoat subject to a .3 percent limit each day from the previous day’s closing value against a set of major currencies. This adjustment by China seemed to reduce the criticism about the yuan being held to a superﬁcially weak level, but it did not have a major impact on the trade imbalance between China and the United States. In May 2007, China widened its band so that the yuan’s value could ﬂoat subject to a .5 percent limit each day. Even though the yuan is now allowed to ﬂoat (within limits), the huge balanceof-trade deﬁcit will not automatically force appreciation of the yuan. Large net capital ﬂows from China to the United States (purchases of U.S. securities) could offset the trade ﬂows.

Currency Boards Used to Peg Currency Values. A currency board is a system for pegging the value of the local currency to some other speciﬁed currency. The board must maintain currency reserves for all the currency that it has printed. The large amount of reserves may increase the ability of a country’s central bank to maintain its pegged currency. Hong Kong has tied the value of its currency (the Hong Kong dollar) to the U.S. dollar (HK$7.80 $1.00) since 1983. Every Hong Kong dollar in circulation is backed by a U.S. dollar in reserve. In 2000, El Salvador set its currency (the colon) to be valued at 8.75 per U.S. dollar. ■

E X A M P L E

A currency board can stabilize a currency’s value. This is important because investors generally avoid investing in a country if they expect the local currency will weaken substantially. If a currency board is expected to remain in place for a long period, it may reduce fears that the local currency will weaken and thus may encourage investors to maintain their investments within the country. However, a currency board is worth considering only if the government can convince investors that the exchange rate will be maintained. When Indonesia was experiencing financial problems during the 1997–1998 Asian crisis, businesses and investors sold the local currency (rupiah) because of expectations that it would weaken further. Such actions perpetuated the weakness, as the exchange of rupiah for other currencies placed more downward pressure on the value of the rupiah. Indonesia considered implementing a currency board to stabilize its currency and discourage the flow of funds out of the country. Businesses and investors had no confidence in the Indonesian government’s ability to maintain a fixed exchange rate, however, and feared that economic pressures would ultimately lead to a decline in the rupiah’s value. Thus, Indonesia’s government did not implement a currency board. ■

E X A M P L E

A currency board is effective only if investors believe that it will last. If investors expect that market forces will prevent a government from maintaining the local currency’s exchange rate, they will attempt to move their funds to other countries where they expect the local currency to be stronger. When foreign investors withdraw their funds from a country and convert the funds into a different currency, they place downward pressure on the local currency’s exchange rate. If the supply of the currency for sale continues to exceed the demand, the government will be forced to devalue its currency. In 1991, Argentina established a currency board that pegged the Argentine peso to the U.S. dollar. In 2002, Argentina was suffering from major economic problems, and its government was unable to repay its debt. Foreign investors and local investors began to transfer their funds to other countries because they feared that their investments would earn poor

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Part 2: Exchange Rate Behavior returns. These actions required the exchange of pesos into other currencies such as the dollar and caused an excessive supply of pesos for sale in the foreign exchange market. The government could not maintain the exchange rate of 1 peso 1 dollar because the supply of pesos for sale exceeded the demand at that exchange rate. In March 2002, the government devalued the peso to 1 peso $.71 (1.4 pesos per dollar). Even at this new exchange rate, the supply of pesos for sale exceeded the demand, so the Argentine government decided to let the peso’s value float in response to market conditions rather than set the peso’s value. ■

Exposure of a Pegged Currency to Interest Rate Movements. A country that uses a currency board does not have complete control over its local interest rates because its rates must be aligned with the interest rates of the currency to which it is tied. Recall that the Hong Kong dollar is pegged to the U.S. dollar. If Hong Kong lowers its interest rates to stimulate its economy, its interest rate would then be lower than U.S. interest rates. Investors based in Hong Kong would be enticed to exchange Hong Kong dollars for U.S. dollars and invest in the United States where interest rates are higher. Since the Hong Kong dollar is tied to the U.S. dollar, the investors could exchange the proceeds of their investment back to Hong Kong dollars at the end of the investment period without concern about exchange rate risk because the exchange rate is fixed. If the United States raises its interest rates, Hong Kong would be forced to raise its interest rates (on securities with similar risk as those in the United States). Otherwise, investors in Hong Kong could invest their money in the United States and earn a higher rate. ■

E X A M P L E

Even though a country may not have control over its interest rate when it establishes a currency board, its interest rate may be more stable than if it did not have a currency board. Its interest rate will move in tandem with the interest rate of the currency to which it is tied. The interest rate may include a risk premium that could reﬂect either default risk or the risk that the currency board will be discontinued. While the Hong Kong interest rate moves in tandem with the U.S. interest rate, specific investment instruments may have a slightly higher interest rate in Hong Kong than in the United States. For example, a Treasury bill may offer a slightly higher rate in Hong Kong than in the United States. While this allows for possible arbitrage by U.S. investors who wish to invest in Hong Kong, they will face two forms of risk. First, some investors may believe that there is a slight risk that the Hong Kong government could default on its debt. Second, if there is sudden downward pressure on the Hong Kong dollar, the currency board could be discontinued. In this case, the Hong Kong dollar’s value would be reduced, and U.S. investors would earn a lower return than they could have earned in the United States. ■

E X A M P L E

Exposure of a Pegged Currency to Exchange Rate Movements. A currency that is pegged to another currency cannot be pegged against all other currencies. If it is pegged to the U.S. dollar, it is forced to move in tandem with the dollar against other currencies. Since a country cannot peg its currency to all currencies, it is exposed to movements of currencies against the currency to which it is pegged. As mentioned earlier, from 1991 to 2002, the Argentine peso’s value was set to equal one U.S. dollar. Thus, if the dollar strengthened against the Brazilian real by 10 percent in a particular month, the Argentine peso strengthened against the Brazilian real by the exact same amount. During the 1991–2002 period, the dollar commonly strengthened against the Brazilian real and some other currencies in South America; therefore, the Argentine peso also strengthened against those currencies. Many exporting firms in Argentina were adversely

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affected by the strong Argentine peso, however, because it made their products too expensive for importers. Now that Argentina’s currency board has been eliminated, the Argentine peso is no longer forced to move in tandem with the dollar against other currencies. ■

Dollarization Dollarization is the replacement of a foreign currency with U.S. dollars. This process

is a step beyond a currency board because it forces the local currency to be replaced by the U.S. dollar. Although dollarization and a currency board both attempt to peg the local currency’s value, the currency board does not replace the local currency with dollars. The decision to use U.S. dollars as the local currency cannot be easily reversed because the country no longer has a local currency. From 1990 to 2000, Ecuador’s currency (the sucre) depreciated by about 97 percent against the U.S. dollar. The weakness of the currency caused unstable trade conditions, high inflation, and volatile interest rates. In 2000, in an effort to stabilize trade and economic conditions, Ecuador replaced the sucre with the U.S. dollar as its currency. By November 2000, inflation had declined and economic growth had increased. Thus, it appeared that dollarization had favorable effects. ■

E X A M P L E

Classification of Exchange Rate Arrangements Exhibit 6.1 identiﬁes the currencies and exchange rate arrangements used by various countries. Many countries allow the value of their currency to ﬂoat against others but intervene periodically to inﬂuence its value. Several small countries peg their currencies to the U.S. dollar. The Mexican peso has a controlled exchange rate that applies to international trade and a ﬂoating market rate that applies to tourism. The ﬂoating market rate is inﬂuenced by central bank intervention. Chile intervenes to maintain its currency within 10 percent of a speciﬁed exchange rate with respect to major currencies. Venezuela intervenes to limit exchange rate ﬂuctuations within wide bands. Eastern European countries that have opened their markets have tied their currencies to a single widely traded currency. The arrangement was sometimes temporary, as these countries were searching for the proper exchange rate that would stabilize or enhance their economic conditions. For example, the government of Slovakia devalued its currency (the koruna) in an attempt to increase foreign demand for its goods and reduce unemployment. Many governments attempt to impose exchange controls to prevent their exchange rates from ﬂuctuating. When these governments remove the controls, however, the exchange rates abruptly adjust to a new market-determined level. For example, in October 1994, the Russian authorities allowed the Russian ruble to ﬂuctuate, and the ruble depreciated by 27 percent against the U.S. dollar on that day. In April 1996, Venezuela’s government removed controls on the bolivar (its currency), and the bolivar depreciated by 42 percent on that day. After the 2001 war in Afghanistan, an exchange rate system was needed there. In October 2002, a new currency, called the new afghani, was created to replace the old afghani. The old currency was exchanged for the new money at a ratio of 1,000 to 1. Thus, 30,000 old afghanis were exchanged for 30 new afghanis. The new money was printed with watermarks to deter counterfeits. In 2003, three different currencies were being used in Iraq. The Swiss dinar (so called because it was designed in Switzerland) was created before the Gulf War but had not been printed since then. It traded at about 8 dinars per dollar and was used by the Kurds in northern Iraq. The Saddam dinar, which was used extensively before 2003, was printed in excess to ﬁ nance Iraq’s military budget and was easy to

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Part 2: Exchange Rate Behavior Exhibit 6.1

Exchange Rate Arrangements Floating Rate System

Country

Currency

Country

Currency

Afghanistan

new afghani

Norway

krone

Argentina

peso

Paraguay

guarani

Australia

dollar

Peru

new sol

Bolivia

boliviano

Poland

zloty

Brazil

real

Romania

leu

Canada

dollar

Russia

ruble

Chile

peso

Singapore

dollar

Euro participants

euro

South Africa

rand

Hungary

forint

South Korea

won

India

rupee

Sweden

krona

Indonesia

rupiah

Switzerland

franc

Israel

new shekel

Taiwan

new dollar

Jamaica

dollar

Thailand

baht

Japan

yen

United Kingdom

pound

Mexico

peso

Venezuela

bolivar

Pegged Rate System The following currencies are pegged to the U.S. dollar. Country

Currency

Country

Currency

Bahamas

dollar

Hong Kong

dollar

Barbados

dollar

Saudi Arabia

riyal

Bermuda

dollar

counterfeit. Its value relative to the dollar was very volatile over time. The U.S. dollar was frequently used in the black market in Iraq even before the 2003 war. In 2004, the new Iraqi dinar was created and replaced the Swiss dinar and Saddam dinar to become the national currency. Its initial value was set at about $.0007. The new dinar’s value is allowed to ﬂuctuate in accordance with market forces but has been somewhat stable over time.

A Single European Currency In 1991, the Maastricht Treaty called for the establishment of a single European currency. As of January 1, 1999, the euro replaced the national currencies of 11 European countries for the purpose of commercial transactions executed through electronic transfers and other forms of payment. By June 1, 2002, when the national currencies were to be withdrawn from the ﬁ nancial system and replaced with the euro, a twelfth country had qualiﬁed for the euro.

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Membership The agreement to adopt the euro was a major historical event. Countries that had previously been at war with each other at various times in the past were now willing to work together toward a common cause. Of the 27 countries that are members of the European Union (EU), 13 countries participate in the euro: Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Slovenia, and Spain. Together, the participating countries comprise almost 20 percent of the world’s gross domestic product, a proportion similar to that of the United States. Three countries that were members of the EU in 1999 (the United Kingdom, Denmark, and Sweden) decided not to adopt the euro at that time. The 10 countries in Eastern Europe (including the Czech Republic and Hungary) that joined the EU in 2004 are eligible to participate in the euro if they meet speciﬁc economic goals. Slovenia adopted the euro in 2007. Countries that participate in the EU are supposed to abide by the Stability and Growth pact before they adopt the euro. This pact requires that the country’s budget deﬁcit be less than 3 percent of its gross domestic product. However, there are frequent allegations that some of the existing EU countries that presently participate in the euro have a budget deﬁcit that exceeds their allowable limit.

Impact on European Monetary Policy The euro allows for a single money supply throughout much of Europe, rather than a separate money supply for each participating currency. Thus, European monetary policy is consolidated because any effects on the money supply will have an impact on all European countries using the euro as their form of money. The implementation of a common monetary policy may promote more political unity among European countries with similar national defense and foreign policies.

European Central Bank. The European Central Bank (ECB) is based in Frankfurt and is responsible for setting monetary policy for all participating European countries. Its objective is to control inﬂation in the participating countries and to stabilize (within reasonable boundaries) the value of the euro with respect to other major currencies. Thus, the ECB’s monetary goals of price stability and currency stability are similar to those of individual countries around the world, but differ in that they are focused on a group of countries instead of a single country. Implications of a European Monetary Policy. Although a single European monetary policy may allow for more consistent economic conditions across countries, it prevents any individual European country from solving local economic problems with its own unique monetary policy. European governments may disagree on the ideal monetary policy to enhance their local economies, but they must agree on a single European monetary policy. Any given policy used in a particular period may enhance conditions in some countries and adversely affect others. Each participating country is still able to apply its own ﬁ scal policy (tax and government expenditure decisions), however. The use of a common currency may someday create more political harmony among European countries.

Impact on Business within Europe The euro enables residents of participating countries to engage in cross-border trade ﬂows and capital ﬂows throughout the so-called euro zone (of participating countries) without converting to a different currency. The elimination of currency movements among European countries also encourages more long-term business arrangements between ﬁ rms of different countries, as they no longer have to worry about adverse effects due to currency movements. Thus, ﬁ rms in different European countries are

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increasingly engaging in all types of business arrangements including licensing, joint ventures, and acquisitions. Prices of products are now more comparable among European countries, as the exchange rate between the countries is ﬁ xed. Thus, buyers can more easily determine where they can obtain products at the lowest cost. Trade ﬂows between the participating European countries have increased because exporters and importers can conduct trade without concern about exchange rate movements. To the extent that there are more trade ﬂows between these countries, economic conditions in each of these countries should have a larger impact on the other European countries, and economies of these countries may become more integrated.

Impact on the Valuation of Businesses in Europe When ﬁ rms consider acquiring targets in Europe, they can more easily compare the prices (market values) of targets among countries because their values are denominated in the same currency (the euro). In addition, the future currency movements of the target’s currency against any non-European currency will be the same. Therefore, U.S. ﬁ rms can more easily conduct valuations of ﬁ rms across the participating European countries because when funds are remitted to the U.S. parent from any of the participating countries, the level of appreciation or depreciation will be the same for a particular period and there will be no differences in exchange rate effects. European ﬁ rms face more pressure to perform well because they can be measured against all other ﬁ rms in the same industry throughout the participating countries, not just within its own country. Therefore, these ﬁ rms are more focused on meeting various performance goals.

Impact on Financial Flows

H T T P : // http://www.ecb.int/home/ html/index.en.html Information on the euro and monetary policy conducted by the European Central Bank.

A single European currency forces the interest rate offered on government securities to be similar across the participating European countries. Any discrepancy in rates would encourage investors within these European countries to invest in the currency with the highest rate, which would realign the interest rates among these countries. However, the rate may still vary between two government securities with the same maturity if they exhibit different levels of credit risk. Stock prices are now more comparable among the European countries because they are denominated in the same currency. Investors in the participating European countries are now able to invest in stocks throughout these countries without concern about exchange rate risk. Thus, there is more cross-border investing than there was in the past. Since stock market prices are inﬂuenced by expectations of economic conditions, the stock prices among the European countries may become more highly correlated if economies among these countries become more highly correlated. Investors from other countries who invest in European countries may not achieve as much diversiﬁcation as in the past because of the integration and because the exchange rate effects will be the same for all markets whose stocks are denominated in euros. Stock markets in these European countries are also likely to consolidate over time now that they use the same currency. Bond investors based in these European countries can now invest in bonds issued by governments and corporations in these countries without concern about exchange rate risk, as long as the bonds are denominated in euros. Some European governments have already issued bonds that are redenominated in euros because the secondary market for some bonds issued in Europe with other currency denominations is now less active. The bond yields in participating European countries are not

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necessarily similar even though they are now denominated in the same currency; the credit risk may still be higher for issuers in a particular country.

Impact on Exchange Rate Risk One major advantage of a single European currency is the complete elimination of exchange rate risk between the participating European countries, which could encourage more trade and capital ﬂows across European borders. In addition, foreign exchange transaction costs associated with transactions between European countries have been eliminated. The single European currency is consistent with the goal of the Single European Act to remove trade barriers between European borders since exchange rate risk is an implicit trade barrier. The euro’s value with respect to the U.S. dollar changes continuously. The euro’s value is inﬂuenced by the trade ﬂows and capital ﬂows between the set of participating European countries and the United States since these ﬂows affect supply and demand conditions. Its value with respect to the Japanese yen is inﬂuenced by the trade ﬂows and capital ﬂows between the set of participating European countries and Japan. European countries that participate in the euro are still affected by movements in its value with respect to other currencies such as the dollar. Furthermore, many U.S. ﬁ rms are still affected by movements in the euro’s value with respect to the dollar.

Status Report on the Euro The euro has experienced a volatile ride since it was introduced in 1999. Its value initially declined substantially against the British pound, the U.S. dollar, and many other currencies. In October 2001, for example, 33 months after it was introduced, its value was $.88, or about 27 percent less than its initial value. The weakness was partially attributed to capital outﬂows from Europe. By April 2007, however, the euro was valued at $1.35, or 53 percent above its value in October 2001. The rebound in the euro was triggered by the relatively high European interest rates compared to U.S. interest rates in the 2001–2003 period, which attracted capital inﬂows into Europe.

Government Intervention H T T P : // http://www.bis.org/ cbanks.htm Links to websites of central banks around the world; some of the websites are in English.

Each country has a central bank that may intervene in the foreign exchange markets to control its currency’s value. In the United States, for example, the central bank is the Federal Reserve System (the Fed). Central banks have other duties besides intervening in the foreign exchange market. In particular, they attempt to control the growth of the money supply in their respective countries in a way that will favorably affect economic conditions.

Reasons for Government Intervention The degree to which the home currency is controlled, or “managed,” varies among central banks. Central banks commonly manage exchange rates for three reasons: • To smooth exchange rate movements • To establish implicit exchange rate boundaries • To respond to temporary disturbances

Smooth Exchange Rate Movements. If a central bank is concerned that its economy will be affected by abrupt movements in its home currency’s value, it may attempt to smooth the currency movements over time. Its actions may keep

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business cycles less volatile. The central bank may also encourage international trade by reducing exchange rate uncertainty. Furthermore, smoothing currency movements may reduce fears in the ﬁ nancial markets and speculative activity that could cause a major decline in a currency’s value.

Establish Implicit Exchange Rate Boundaries. Some central banks attempt to maintain their home currency rates within some unofﬁcial, or implicit, boundaries. Analysts are commonly quoted as forecasting that a currency will not fall below or rise above a particular benchmark value because the central bank would intervene to prevent that. The Federal Reserve periodically intervenes to reverse the U.S. dollar’s upward or downward momentum. Respond to Temporary Disturbances. In some cases, a central bank may intervene to insulate a currency’s value from a temporary disturbance. In fact, the stated objective of the Fed’s intervention policy is to counter disorderly market conditions. News that oil prices might rise could cause expectations of a future decline in the value of the Japanese yen because Japan exchanges yen for U.S. dollars to purchase oil from oil-exporting countries. Foreign exchange market speculators may exchange yen for dollars in anticipation of this decline. Central banks may therefore intervene to offset the immediate downward pressure on the yen caused by such market transactions. ■

E X A M P L E

Several studies have found that government intervention does not have a permanent impact on exchange rate movements. In many cases, intervention is overwhelmed by market forces. In the absence of intervention, however, currency movements would be even more volatile.

Direct Intervention H T T P : // http://www.ny.frb.org/ markets/foreignex.html Information on the recent direct intervention in the foreign exchange market by the Federal Reserve Bank of New York.

To force the dollar to depreciate, the Fed can intervene directly by exchanging dollars that it holds as reserves for other foreign currencies in the foreign exchange market. By “ﬂooding the market with dollars” in this manner, the Fed puts downward pressure on the dollar. If the Fed desires to strengthen the dollar, it can exchange foreign currencies for dollars in the foreign exchange market, thereby putting upward pressure on the dollar. The effects of direct intervention on the value of the British pound are illustrated in Exhibit 6.2. To strengthen the pound’s value (or to weaken the dollar), the Fed exchanges dollars for pounds, which causes an outward shift in the demand for pounds in the foreign exchange market (as shown in the graph on the left). Conversely, to weaken the pound’s value (or to strengthen the dollar), the Fed exchanges pounds for dollars, which causes an outward shift in the supply of pounds for sale in the foreign exchange market (as shown in the graph on the right). During early 2004, Japan’s central bank, the Bank of Japan, intervened on several occasions to lower the value of the yen. In the ﬁ rst 2 months of 2004, the Bank of Japan sold yen in the foreign exchange market in exchange for $100 billion. Then, on March 5, 2004, the Bank of Japan sold yen in the foreign exchange market in exchange for $20 billion, which put immediate downward pressure on the value of the yen. Direct intervention is usually most effective when there is a coordinated effort among central banks. If all central banks simultaneously attempt to strengthen or weaken the currency in the manner just described, they can exert greater pressure on the currency’s value.

Chapter 6: Government Influence on Exchange Rates Exhibit 6.2

169

Effects of Direct Central Bank Intervention in the Foreign Exchange Market

Fed Exchanges $ for £

Fed Exchanges £ for $

S1

S1

Value of £

Value of £

S2

V2 V1

V1 V2

D2 D1

Quantity of £

D1

Quantity of £

Reliance on Reserves. The potential effectiveness of a central bank’s direct intervention is the amount of reserves it can use. For example, the central bank of China has a substantial amount of reserves that it can use to intervene in the foreign exchange market. Thus, it can more effectively use direct intervention than many other countries in Asia. If the central bank has a low level of reserves, it may not be able to exert much pressure on the currency’s value. Market forces would likely overwhelm its actions. As foreign exchange activity has grown, central bank intervention has become less effective. The volume of foreign exchange transactions on a single day now exceeds the combined values of reserves at all central banks. Consequently, the number of direct interventions has declined. In 1989, for example, the Fed intervened on 97 different days. Since then, the Fed has not intervened on more than 20 days in any year.

Nonsterilized versus Sterilized Intervention. When the Fed intervenes in the foreign exchange market without adjusting for the change in the money supply, it is engaging in a nonsterilized intervention. For example, if the Fed exchanges dollars for foreign currencies in the foreign exchange markets in an attempt to strengthen foreign currencies (weaken the dollar), the dollar money supply increases. In a sterilized intervention, the Fed intervenes in the foreign exchange market and simultaneously engages in offsetting transactions in the Treasury securities markets. As a result, the dollar money supply is unchanged. If the Fed desires to strengthen foreign currencies (weaken the dollar) without affecting the dollar money supply, it (1) exchanges dollars for foreign currencies and (2) sells some of its holdings of Treasury securities for dollars. The net effect is an increase in investors’ holdings of Treasury securities and a decrease in bank foreign currency balances. ■

E X A M P L E

The difference between nonsterilized and sterilized intervention is illustrated in Exhibit 6.3. In the top section of the exhibit, the Federal Reserve attempts

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Part 2: Exchange Rate Behavior

Exhibit 6.3

Forms of Central Bank Intervention in the Foreign Exchange Market

Nonsterilized Intervention to Strengthen the Canadian Dollar Federal Reserve

Sterilized Intervention to Strengthen the Canadian Dollar Federal Reserve Treasury Securities

$

$

C$

C$ $

Banks Participating in the Foreign Exchange Market

Banks Participating in the Foreign Exchange Market

Sterilized Intervention to Weaken the Canadian Dollar

Nonsterilized Intervention to Weaken the Canadian Dollar Federal Reserve $

Federal Reserve $

C$

Banks Participating in the Foreign Exchange Market

Financial Institutions That Invest in Treasury Securities

C$

Banks Participating in the Foreign Exchange Market

$ Treasury Securities Financial Institutions That Invest in Treasury Securities

to strengthen the Canadian dollar, and in the bottom section, the Federal Reserve attempts to weaken the Canadian dollar. For each scenario, the graph on the right shows a sterilized intervention involving an exchange of Treasury securities for U.S. dollars that offsets the U.S. dollar ﬂows resulting from the exchange of currencies. Thus, the sterilized intervention achieves the same exchange of currencies in the foreign exchange market as the nonsterilized intervention, but it involves an additional transaction to prevent adjustments in the U.S. dollar money supply.

Speculating on Direct Intervention. Some traders in the foreign exchange market attempt to determine when Federal Reserve intervention is occurring, and the extent of the intervention, in order to capitalize on the anticipated results of the intervention effort. Normally, the Federal Reserve attempts to intervene without being noticed. However, dealers at the major banks that trade with the Fed often pass the information to other market participants. Also, when the Fed deals directly with numerous commercial banks, markets are well aware that the Fed is intervening. To hide its strategy, the Fed may pretend to be interested in selling dollars when it is actually buying dollars, or vice versa. It calls commercial banks and obtains both bid and ask quotes on currencies, so the banks will not know whether the Fed is considering purchases or sales of these currencies. Intervention strategies vary among central banks. Some arrange for one large order when they intervene; others use several smaller orders equivalent to $5 million to $10 million. Even if traders determine the extent of central bank intervention, they still cannot know with certainty what impact it will have on exchange rates.

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Indirect Intervention The Fed can also affect the dollar’s value indirectly by inﬂuencing the factors that determine it. Recall that the change in a currency’s spot rate is inﬂuenced by the following factors: e = f(INF, INT, INC, GC, EXP) where e percentage change in the spot rate INF change in the differential between U.S. inﬂation and the foreign country’s inﬂation INT change in the differential between the U.S. interest rate and the foreign country’s interest rate INC change in the differential between the U.S. income level and the foreign country’s income level GC change in government controls EXP change in expectations of future exchange rates The central bank can inﬂuence all of these variables, which in turn can affect the exchange rate. Since these variables will likely have a more lasting impact on a spot rate than direct intervention, a central bank may use indirect intervention by inﬂuencing these variables. Although the central bank can inﬂuence all of these variables, it is likely to focus on interest rates or government controls when using indirect intervention.

Government Adjustment of Interest Rates. When countries experience substantial net outﬂows of funds (which places severe downward pressure on their currency), they commonly intervene indirectly by raising interest rates to discourage excessive outﬂows of funds and therefore limit any downward pressure on the value of their currency. However, this strategy adversely affects local borrowers (government agencies, corporations, and consumers) and may weaken the economy. The Fed can attempt to lower interest rates by increasing the U.S. money supply (assuming that inflationary expectations are not affected). Lower U.S. interest rates tend to discourage foreign investors from investing in U.S. securities, thereby placing downward pressure on the value of the dollar. Or, to boost the dollar’s value, the Fed can attempt to increase interest rates by reducing the U.S. money supply. It has commonly used this strategy along with direct intervention in the foreign exchange market. ■

E X X A M P L E

In October 1997, there was concern that the Asian crisis might adversely affect Brazil and other Latin American countries. Speculators pulled funds out of Brazil and reinvested them in other countries, causing major capital outflows and therefore placing extreme downward pressure on the Brazilian currency (the real). The central bank of Brazil responded at the end of October by doubling its interest rates from about 20 percent to about 40 percent. This action discouraged investors from pulling funds out of Brazil because they could now earn twice the interest from investing in some securities there. Although the bank’s action was successful in defending the real, it reduced economic growth because the cost of borrowing funds was too high for many firms. In another example, during the Asian crisis in 1997 and 1998, central banks of some Asian countries increased their interest rates to prevent their currencies from weakening. The higher interest rates were expected to make the local securities more attractive and therefore encourage investors to maintain their holdings of securities, which would reduce the exchange of the local currency for other currencies. This effort was not successful for most Asian countries, although it worked for China and Hong Kong.

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Part 2: Exchange Rate Behavior As a third example, in May 1998, the Russian currency (the ruble) had consistently declined, and Russian stock prices had fallen by more than 50 percent from their level 4 months earlier. Fearing that the lack of confidence in Russia’s currency and stocks would cause massive outflows of funds, the Russian central bank attempted to prevent further outflows by tripling interest rates (from about 50 to 150 percent). The ruble was temporarily stabilized, but stock prices continued to decline because investors were concerned that the high interest rates would reduce economic growth. ■

Government Use of Foreign Exchange Controls. Some governments attempt to use foreign exchange controls (such as restrictions on the exchange of the currency) as a form of indirect intervention to maintain the exchange rate of their currency. Under severe pressure, however, they tend to let the currency ﬂoat temporarily toward its market-determined level and set new bands around that level. During the mid-1990s, Venezuela imposed foreign exchange controls on its currency (the bolivar). In April 1996, Venezuela removed its controls on foreign exchange, and the bolivar declined by 42 percent the next day. This result suggests that the market-determined exchange rate of the bolivar was substantially lower than the exchange rate at which the government artificially set the bolivar. ■

E X A M P L E

Intervention as a Policy Tool The government of any country can implement its own ﬁscal and monetary policies to control its economy. In addition, it may attempt to inﬂuence the value of its home currency in order to improve its economy, weakening its currency under some conditions and strengthening it under others. In essence, the exchange rate becomes a tool, like tax laws and the money supply, that the government can use to achieve its desired economic objectives.

Influence of a Weak Home Currency on the Economy A weak home currency can stimulate foreign demand for products. A weak dollar, for example, can substantially boost U.S. exports and U.S. jobs. In addition, it may also reduce U.S. imports. Though a weak currency can reduce unemployment at home, it can lead to higher inﬂation. In the early 1990s, the U.S. dollar was weak, causing U.S. imports from foreign countries to be highly priced. This situation priced ﬁ rms such as Bayer, Volkswagen, and Volvo out of the U.S. market. Under these conditions, U.S. companies were able to raise their domestic prices because it was difﬁcult for foreign producers to compete. In addition, U.S. ﬁ rms that are heavy exporters, such as Goodyear Tire & Rubber Co., Northrup Grumman, Merck, DuPont, and Whirlpool, also beneﬁt from a weaker dollar.

Influence of a Strong Home Currency on the Economy A strong home currency can encourage consumers and corporations of that country to buy goods from other countries. This situation intensiﬁes foreign competition and

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forces domestic producers to refrain from increasing prices. Therefore, the country’s overall inﬂation rate should be lower if its currency is stronger, other things being equal. Though a strong currency is a possible cure for high inﬂation, it may cause higher unemployment due to the attractive foreign prices that result from a strong home currency. The ideal value of the currency depends on the perspective of the country and the ofﬁcials who must make these decisions. The strength or weakness of a currency is just one of many factors that inﬂuence a country’s economic conditions. By combining this discussion of how exchange rates affect inﬂ ation with the discussion in Chapter 4 of how inﬂation can affect exchange rates, a more complete picture of the dynamics of the exchange rate–inﬂation relationship can be achieved. A weak dollar places upward pressure on U.S. inﬂation, which in turn places further downward pressure on the value of the dollar. A strong dollar places downward pressure on inﬂation and on U.S. economic growth, which in turn places further upward pressure on the dollar’s value. The interaction among exchange rates, government policies, and economic factors is illustrated in Exhibit 6.4. As already mentioned, factors other than the home currency’s strength affect unemployment and/or inﬂation. Likewise, factors other than unemployment and the inﬂation level inﬂuence a currency’s strength. The cycles that have been described here will often be interrupted by these other factors and therefore will not continue indeﬁ nitely.

Exhibit 6.4 Impact of Government Actions on Exchange Rates

Government Monetary and Fiscal Policies

Relative Interest Rates

Relative Inﬂation Rates

Relative National Income Levels

International Capital Flows

Exchange Rates

International Trade

Government Purchases and Sales of Currencies

Tax Laws, etc.

Government Intervention in Foreign Exchange Market

Quotas, Tariffs, etc.

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SUMMARY ■ Exchange rate systems can be classiﬁed as ﬁ xed rate, freely ﬂoating, managed ﬂoat, and pegged. In a ﬁ xed exchange rate system, exchange rates are either held constant or allowed to ﬂuctuate only within very narrow boundaries. In a freely ﬂoating exchange rate system, exchange rate values are determined by market forces without intervention. In a managed ﬂoat system, exchange rates are not restricted by boundaries but are subject to government intervention. In a pegged exchange rate system, a currency’s value is pegged to a foreign currency or a unit of account and moves in line with that currency (or unit of account) against other currencies. ■ Governments can use direct intervention by purchasing or selling currencies in the foreign exchange market, thereby affecting demand and supply conditions and, in turn, affecting the equilibrium values of the currencies. When a government purchases a currency in the foreign exchange market, it puts upward pressure on the currency’s equilibrium value. When a government sells a currency in the foreign exchange market, it puts downward pressure on the currency’s equilibrium value.

POINT

■ Governments can use indirect intervention by inﬂuencing the economic factors that affect equilibrium exchange rates. ■ When government intervention is used to weaken the U.S. dollar, the weak dollar can stimulate the U.S. economy by reducing the U.S. demand for imports and increasing the foreign demand for U.S. exports. Thus, the weak dollar tends to reduce U.S. unemployment, but it can increase U.S. inﬂation. When government intervention is used to strengthen the U.S. dollar, the strong dollar can increase the U.S. demand for imports, thereby intensifying foreign competition. The strong dollar can reduce U.S. inﬂation but may cause a higher level of U.S. unemployment.

COUNTER-POINT

Should China Be Forced to Alter the Value of Its Currency? Point U.S. politicians frequently suggest that China needs to increase the value of the Chinese yuan against the U.S. dollar, even though China has allowed the yuan to ﬂoat (within boundaries). The U.S. politicians claim that the yuan is the cause of the large U.S. trade deﬁcit with China. This issue is periodically raised not only with currencies tied to the dollar but also with currencies that have a ﬂoating rate. Some critics argue that the exchange rate can be used as a form of trade protectionism. That is, a country can discourage or prevent imports and encourage exports by keeping the value of its currency artiﬁcially low. Counter-Point China might counter that its large balance-of-trade surplus with the United States has been due to the difference in prices between the two countries and that it should not be blamed for the high U.S. prices. It might argue that the U.S. trade deﬁcit can be partially attributed to the very high prices in the United States, which are necessary to cover the

excessive compensation for executives and other employees at U.S. ﬁ rms. The high prices in the United States encourage ﬁ rms and consumers to purchase goods from China. Even if China’s yuan is revalued upward, this does not necessarily mean that U.S. ﬁ rms and consumers will purchase U.S. products. They may shift their purchases from China to Indonesia or other low-wage countries rather than buy more U.S. products. Thus, the underlying dilemma is not China but any country that has lower costs of production than the United States. Who Is Correct? Use the Internet to learn more about this issue. Which argument do you support? Offer your own opinion on this issue.

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TEST

Answers are provided in Appendix A at the back of the text. 1. Explain why it would be virtually impossible to set an exchange rate between the Japanese yen and the U.S. dollar and to maintain a ﬁxed exchange rate.

3. Brieﬂy explain why the Federal Reserve may attempt to weaken the dollar.

2. Assume the Federal Reserve believes that the dollar should be weakened against the Mexican peso.

QUESTIONS

AND

Explain how the Fed could use direct and indirect intervention to weaken the dollar’s value with respect to the peso. Assume that future inflation in the United States is expected to be low, regardless of the Fed’s actions.

A P P L I CAT I O N S

1. Exchange Rate Systems. Compare and contrast the ﬁ xed, freely ﬂoating, and managed ﬂoat exchange rate systems. What are some advantages and disadvantages of a freely ﬂoating exchange rate system versus a ﬁ xed exchange rate system? 2. Intervention with Euros. Assume that Belgium, one of the European countries that uses the euro as its currency, would prefer that its currency depreciate against the U.S. dollar. Can it apply central bank intervention to achieve this objective? Explain. 3. Direct Intervention. How can a central bank use direct intervention to change the value of a currency? Explain why a central bank may desire to smooth exchange rate movements of its currency. 4. Indirect Intervention. How can a central bank use indirect intervention to change the value of a currency? 5. Intervention Effects. Assume there is concern that the United States may experience a recession. How should the Federal Reserve inﬂuence the dollar to prevent a recession? How might U.S. exporters react to this policy (favorably or unfavorably)? What about U.S. importing ﬁ rms? 6. Currency Effects on Economy. What is the impact of a weak home currency on the home economy, other things being equal? What is the impact of a strong home currency on the home economy, other things being equal? 7. Feedback Effects. Explain the potential feedback effects of a currency’s changing value on inﬂation. 8. Indirect Intervention. Why would the Fed’s indirect intervention have a stronger impact on some currencies than others? Why would a central bank’s indirect intervention have a stronger impact than its direct intervention?

9. Effects on Currencies Tied to the Dollar. The Hong Kong dollar’s value is tied to the U.S. dollar. Explain how the following trade patterns would be affected by the appreciation of the Japanese yen against the dollar: (a) Hong Kong exports to Japan and (b) Hong Kong exports to the United States. 10. Intervention Effects on Bond Prices. U.S. bond prices are normally inversely related to U.S. inﬂation. If the Fed planned to use intervention to weaken the dollar, how might bond prices be affected? 11. Direct Intervention in Europe. If most countries in Europe experience a recession, how might the European Central Bank use direct intervention to stimulate economic growth? 12. Sterilized Intervention. Explain the difference between sterilized and nonsterilized intervention. 13. Effects of Indirect Intervention. Suppose that the government of Chile reduces one of its key interest rates. The values of several other Latin American currencies are expected to change substantially against the Chilean peso in response to the news. a. Explain why other Latin American currencies

could be affected by a cut in Chile’s interest rates. b. How would the central banks of other Latin

American countries likely adjust their interest rates? How would the currencies of these countries respond to the central bank intervention? c. How would a U.S. ﬁ rm that exports products to

Latin American countries be affected by the central bank intervention? (Assume the exports are denominated in the corresponding Latin American currency for each country.)

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14. Freely Floating Exchange Rates. Should the governments of Asian countries allow their currencies to ﬂoat freely? What would be the advantages of letting their currencies ﬂoat freely? What would be the disadvantages? 15. Indirect Intervention. During the Asian crisis, some Asian central banks raised their interest rates to prevent their currencies from weakening. Yet, the currencies weakened anyway. Offer your opinion as to why the central banks’ efforts at indirect intervention did not work. Advanced Questions 16. Monitoring of the Fed’s Intervention. Why do foreign market participants attempt to monitor the Fed’s direct intervention efforts? How does the Fed attempt to hide its intervention actions? The media frequently report that “the dollar’s value strengthened against many currencies in response to the Federal Reserve’s plan to increase interest rates.” Explain why the dollar’s value may change even before the Federal Reserve affects interest rates. 17. Effects of September 11. Within a few days after the September 11, 2001, terrorist attack on the United States, the Federal Reserve reduced shortterm interest rates to stimulate the U.S. economy. How might this action have affected the foreign ﬂow of funds into the United States and affected the value of the dollar? How could such an effect on the dollar have increased the probability that the U.S. economy would strengthen? 18. Intervention Effects on Corporate Performance. Assume you have a subsidiary in Australia. The subsidiary sells mobile homes to local consumers in Australia, who buy the homes using mostly borrowed funds from local banks. Your subsidiary purchases all of its materials from Hong Kong. The Hong Kong dollar is tied to the U.S. dollar. Your subsidiary borrowed funds from the U.S. parent, and must pay the parent $100,000 in interest each month. Australia has just raised its interest rate in order to boost the value of its currency (Australian dollar, A$). The Australian dollar appreciates against the U.S. dollar as a result. Explain whether these actions would increase, reduce, or have no effect on: a. The volume of your subsidiary’s sales in Australia

(measured in A$). b. The cost to your subsidiary of purchasing materi-

als (measured in A$).

c. The cost to your subsidiary of making the interest payments to the U.S. parent (measured in A$).

Brieﬂy explain each answer. 19. Pegged Currencies. Why do you think a country suddenly decides to peg its currency to the dollar or some other currency? When a currency is unable to maintain the peg, what do you think are the typical forces that break the peg? 20. Impact of Intervention on Currency Option Premiums. Assume that the central bank of the country Zakow periodically intervenes in the foreign exchange market to prevent large upward or downward ﬂuctuations in its currency (called the zak) against the U.S. dollar. Today, the central bank announced that it will no longer intervene in the foreign exchange market. The spot rate of the zak against the dollar was not affected by this news. Will the news affect the premium on currency call options that are traded on the zak? Will the news affect the premium on currency put options that are traded on the zak? Explain. 21. Impact of Information on Currency Option Premiums. As of 10:00 A.M., the premium on a speciﬁc one-year call option on British pounds is $.04. Assume that the Bank of England had not been intervening in the foreign exchange markets in the last several months. However, it announces at 10:01 A.M. that it will begin to frequently intervene in the foreign exchange market in order to reduce ﬂuctuations in the pound’s value against the U.S. dollar over the next year, but it will not attempt to push the pound’s value higher or lower than what is dictated by market forces. Also, the Bank of England has no plans to affect economic conditions with this intervention. Most participants who trade currency options did not anticipate this announcement. When they heard the announcement, they expected that the intervention will be successful in achieving its goal. Will this announcement cause the premium on the one-year call option on British pounds to increase, decrease, or be unaffected? Explain. Discussion in the Boardroom This exercise can be found in Appendix E at the back of this textbook. Running Your Own MNC This exercise can be found on the Xtra! website at http://maduraxtra.swlearning.com.

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INC.

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CASE

Assessment of Government Influence on Exchange Rates Recall that Blades, the U.S. manufacturer of roller blades, generates most of its revenue and incurs most of its expenses in the United States. However, the company has recently begun exporting roller blades to Thailand. The company has an agreement with Entertainment Products, Inc., a Thai importer, for a 3-year period. According to the terms of the agreement, Entertainment Products will purchase 180,000 pairs of “Speedos,” Blades’ primary product, annually at a ﬁ xed price of 4,594 Thai baht per pair. Due to quality and cost considerations, Blades is also importing certain rubber and plastic components from a Thai exporter. The cost of these components is approximately 2,871 Thai baht per pair of Speedos. No contractual agreement exists between Blades, Inc., and the Thai exporter. Consequently, the cost of the rubber and plastic components imported from Thailand is subject not only to exchange rate considerations but to economic conditions (such as inﬂation) in Thailand as well. Shortly after Blades began exporting to and importing from Thailand, Asia experienced weak economic conditions. Consequently, foreign investors in Thailand feared the baht’s potential weakness and withdrew their investments, resulting in an excess supply of Thai baht for sale. Because of the resulting downward pressure on the baht’s value, the Thai government attempted to stabilize the baht’s exchange rate. To maintain the baht’s value, the Thai government intervened in the foreign exchange market. Speciﬁcally, it swapped its baht reserves for dollar reserves at other central banks and then used its dollar reserves to purchase the baht in the foreign exchange market. However, this agreement required Thailand to reverse this transaction by exchanging dollars for baht at a future date. Unfortunately, the Thai government’s intervention was unsuccessful, as it was overwhelmed by market forces. Consequently, the Thai government ceased its intervention efforts, and the value of the Thai baht declined substantially against the dollar over a 3-month period. When the Thai government stopped intervening in the foreign exchange market, Ben Holt, Blades’ CFO, was concerned that the value of the Thai baht would continue to decline indeﬁ nitely. Since Blades generates net inﬂow in Thai baht, this would seriously affect the company’s proﬁt margin. Furthermore, one of the reasons Blades had expanded into Thailand was to appease the company’s shareholders. At last year’s annual shareholder meeting, they had demanded that senior management take action to improve the ﬁ rm’s low proﬁt

margins. Expanding into Thailand had been Holt’s suggestion, and he is now afraid that his career might be at stake. For these reasons, Holt feels that the Asian crisis and its impact on Blades demand his serious attention. One of the factors Holt thinks he should consider is the issue of government intervention and how it could affect Blades in particular. Speciﬁcally, he wonders whether the decision to enter into a ﬁ xed agreement with Entertainment Products was a good idea under the circumstances. Another issue is how the future completion of the swap agreement initiated by the Thai government will affect Blades. To address these issues and to gain a little more understanding of the process of government intervention, Holt has prepared the following list of questions for you, Blades’ ﬁ nancial analyst, since he knows that you understand international ﬁ nancial management. 1. Did the intervention effort by the Thai government constitute direct or indirect intervention? Explain. 2. Did the intervention by the Thai government constitute sterilized or nonsterilized intervention? What is the difference between the two types of intervention? Which type do you think would be more effective in increasing the value of the baht? Why? (Hint: Think about the effect of nonsterilized intervention on U.S. interest rates.) 3. If the Thai baht is virtually ﬁ xed with respect to the dollar, how could this affect U.S. levels of inﬂation? Do you think these effects on the U.S. economy will be more pronounced for companies such as Blades that operate under trade arrangements involving commitments or for ﬁ rms that do not? How are companies such as Blades affected by a ﬁ xed exchange rate? 4. What are some of the potential disadvantages for Thai levels of inﬂation associated with the ﬂoating exchange rate system that is now used in Thailand? Do you think Blades contributes to these disadvantages to a great extent? How are companies such as Blades affected by a freely ﬂoating exchange rate? 5. What do you think will happen to the Thai baht’s value when the swap arrangement is completed? How will this affect Blades?

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SMALL

BUSINESS

DILEMMA

Assessment of Central Bank Intervention by the Sports Exports Company Jim Logan, owner of the Sports Exports Company, is concerned about the value of the British pound over time because his ﬁ rm receives pounds as payment for footballs exported to the United Kingdom. He recently read that the Bank of England (the central bank of the United Kingdom) is likely to intervene directly in the foreign exchange market by ﬂooding the market with British pounds.

I N T E R N E T/ E XC E L The website for Japan’s central bank, the Bank of Japan, provides information about its mission and its policy actions. Its address is http://www.boj.or.jp/en. 1. Use this website to review the outline of the Bank of Japan’s objectives. Summarize the mission of the Bank of Japan. How does this mission relate to intervening in the foreign exchange market?

1. Forecast whether the British pound will weaken or strengthen based on the information provided. 2. How would the performance of the Sports Exports Company be affected by the Bank of England’s policy of ﬂooding the foreign exchange market with British pounds (assuming that it does not hedge its exchange rate risk)?

EXERCISES 2. Review the minutes of recent meetings by Bank of Japan ofﬁcials. Summarize at least one recent meeting that was associated with possible or actual intervention to affect the yen’s value. 3. Why might the foreign exchange intervention strategies of the Bank of Japan be relevant to the U.S. government and to U.S.-based MNCs?

APPENDIX 6 Government Intervention during the Asian Crisis

From 1990 to 1997, Asian countries achieved higher economic growth than any other countries. They were viewed as models for advances in technology and economic improvement. In the summer and fall of 1997, however, they experienced ﬁ nancial problems, leading to what is commonly referred to as the “Asian crisis,” and resulting in bailouts of several countries by the International Monetary Fund (IMF). Much of the crisis is attributed to the substantial depreciation of Asian currencies, which caused severe ﬁ nancial problems for ﬁ rms and governments throughout Asia, as well as some other regions. This crisis demonstrated how exchange rate movements can affect country conditions and therefore affect the ﬁ rms that operate in those countries. The speciﬁc objectives of this appendix are to describe the conditions in the foreign exchange market that contributed to the Asian crisis, explain how governments intervened in an attempt to control their exchange rates, and describe the consequences of their intervention efforts.

Crisis in Thailand Until July 1997, Thailand was one of the world’s fastest growing economies. In fact, Thailand grew faster than any other country over the 1985–1994 period. Thai consumers spent freely, which resulted in lower savings compared to other Southeast Asian countries. The high level of spending and low level of saving put upward pressure on prices of real estate and products and on the local interest rate. Normally, countries with high inﬂation tend to have weak currencies because of forces from purchasing power parity. Prior to July 1997, however, Thailand’s currency was linked to the U.S. dollar, which made Thailand an attractive site for foreign investors; they could earn a high interest rate on invested funds while being protected (until the crisis) from a large depreciation in the baht.

Bank Lending Situation Normally, countries desire a large inﬂow of funds because it can help support the country’s growth. In Thailand’s case, however, the inﬂow of funds provided Thai banks with more funds than the banks could use for making loans. Consequently, in an attempt to use all the funds, the banks made many very risky loans. Commercial developers borrowed heavily without having to prove that the expansion was feasible. Lenders were willing to lend large sums of money based on the previous success of the developers. The loans may have seemed feasible based on the assumption that the economy would continue its high growth, but such high growth could not last forever. The corporate structure of Thailand also led to excessive lending. Many

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corporations are tied in with banks, such that some bank lending is not an “armslength” business transaction but a loan to a friend that needs funds.

Flow of Funds Situation In addition to the lending situation, the large inﬂow of funds made Thailand more susceptible to a massive outﬂow of funds if foreign investors ever lost conﬁdence in the Thai economy. Given the large amount of risky loans and the potential for a massive outﬂow of funds, Thailand was sometimes described as a “house of cards” waiting to collapse. While the large inﬂow of funds put downward pressure on interest rates, the supply was offset by a strong demand for funds as developers and corporations sought to capitalize on the growth economy by expanding. Thailand’s government was also borrowing heavily to improve the country’s infrastructure. Thus, the massive borrowing was occurring at relatively high interest rates, making the debt expensive to the borrowers.

Export Competition During the ﬁ rst half of 1997, the U.S. dollar strengthened against the Japanese yen and European currencies, which reduced the prices of Japanese and European imports. Although the dollar was linked to the baht over this period, Thailand’s products were not priced as competitively to U.S. importers.

Pressure on the Thai Baht The baht experienced downward pressure in July 1997 as some foreign investors recognized its potential weakness. The outﬂow of funds expedited the weakening of the baht, as foreign investors exchanged their baht for their home currencies. The baht’s value relative to the dollar was pressured by the large sale of baht in exchange for dollars. On July 2, 1997, the baht was detached from the dollar. Thailand’s central bank then attempted to maintain the baht’s value by intervention. Speciﬁcally, it swapped its baht reserves for dollar reserves at other central banks and then used its dollar reserves to purchase the baht in the foreign exchange market (this swap agreement required Thailand to reverse this exchange by exchanging dollars for baht at a future date). The intervention was intended to offset the sales of baht by foreign investors in the foreign exchange market, but market forces overwhelmed the intervention efforts. As the supply of baht for sale exceeded the demand for baht in the foreign exchange market, the government eventually had to surrender in its effort to defend the baht’s value. In July 1997, the value of the baht plummeted. Over a 5-week period, it declined by more than 20 percent against the dollar.

Damage to Thailand Thailand’s central bank used more than $20 billion to purchase baht in the foreign exchange market as part of its direct intervention efforts. Due to the decline in the value of the baht, Thailand needed more baht to be exchanged for the dollars to repay the other central banks. Thailand’s banks estimated the amount of their defaulted loans at over $30 billion. Meanwhile, some corporations in Thailand had borrowed funds in other currencies (including the dollar) because the interest rates in Thailand were relatively high. This strategy backﬁ red because the weakening of the baht forced these corporations to exchange larger amounts of baht for the currencies needed to pay off the loans. Consequently, the corporations incurred a much higher effective ﬁ nancing rate (which accounts for the exchange rate effect to determine the true cost of borrowing) than they would have paid if they had borrowed funds locally in Thailand. The higher borrowing cost was an additional strain on the corporations.

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On August 5, 1997, the IMF and several countries agreed to provide Thailand with a $16 billion rescue package. Japan provided $4 billion, while the IMF provided $4 billion. At the time, this was the second largest bailout plan ever put together for a single country (Mexico had received a $50 billion bailout in 1994). In return for this monetary support, Thailand agreed to reduce its budget deﬁcit, prevent inﬂation from rising above 9 percent, raise its value-added tax from 7 to 10 percent, and clean up the ﬁ nancial statements of the local banks, which had many undisclosed bad loans. The rescue package took time to ﬁ nalize because Thailand’s government was unwilling to shut down all the banks that were experiencing ﬁ nancial problems as a result of their overly generous lending policies. Many critics have questioned the efﬁcacy of the rescue package because some of the funding was misallocated due to corruption in Thailand.

Spread of the Crisis throughout Southeast Asia The crisis in Thailand was contagious to other countries in Southeast Asia. The Southeast Asian economies are somewhat integrated because of the trade between countries. The crisis was expected to weaken Thailand’s economy, which would result in a reduction in the demand for products produced in the other countries of Southeast Asia. As the demand for those countries’ products declined, so would their national income and their demand for products from other Southeast Asian countries. Thus, the effects could perpetuate. Like Thailand, the other Southeast Asian countries had very high growth in recent years, which had led to overly optimistic assessments of future economic conditions and thus to excessive loans being extended for projects that had a high risk of default. These countries were also similar to Thailand in that they had relatively high interest rates, and their governments tended to stabilize their currencies. Consequently, these countries had attracted a large amount of foreign investment as well. Thailand’s crisis made foreign investors realize that such a crisis could also hit the other countries in Southeast Asia. Consequently, they began to withdraw funds from these countries.

Effects on Other Asian Currencies In July and August of 1997, the values of the Malaysian ringgit, Singapore dollar, Philippine peso, Taiwan dollar, and Indonesian rupiah also declined. The Philippine peso was devalued in July. Malaysia initially attempted to maintain the ringgit’s value within a narrow band but then surrendered and let the ringgit ﬂoat to a level determined by market forces. In August 1997, Bank Indonesia (the central bank) used more than $500 million in direct intervention to purchase rupiah in the foreign exchange market in an attempt to boost the value of the rupiah. By mid-August, however, it gave up its effort to maintain the rupiah’s value within a band and let the rupiah ﬂoat to its natural level. This decision by Bank Indonesia to let the rupiah ﬂoat may have been inﬂuenced by the failure of Thailand’s costly efforts to maintain the baht. The market forces were too strong and could not be offset by direct intervention. On October 30, 1997, a rescue package for Indonesia was announced, but the IMF and Indonesia’s government did not agree on the terms of the $43 billion package until the spring of 1998. One of the main points of contention was that President Suharto wanted to peg the rupiah’s exchange rate, but the IMF believed that Bank Indonesia would not be able to maintain the rupiah’s exchange rate at a ﬁ xed level and that it would come under renewed speculative attack. As the Southeast Asian countries gave up their ﬁght to maintain their currencies within bands, they imposed restrictions on their forward and futures markets to

APPENDIX 6

Rescue Package for Thailand

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prevent excessive speculation. For example, Indonesia and Malaysia imposed a limit on the size of forward contracts created by banks for foreign residents. These actions limited the degree to which speculators could sell these currencies forward based on expectations that the currencies would weaken over time. In general, efforts to protect the currencies failed because investors and ﬁ rms had no conﬁdence that the fundamental factors causing weakness in the currencies were being corrected. Therefore, the ﬂow of funds out of the Asian countries continued; this outﬂow led to even more sales of Asian currencies in exchange for other currencies, which put additional downward pressure on the values of the currencies.

Effects on Financing Expenses As the values of the Southeast Asian currencies declined, speculators responded by withdrawing more of their funds from these countries, which led to further weakness in the currencies. As in Thailand, many corporations had borrowed in other countries (such as the United States) where interest rates were relatively low. The decline in the values of their local currencies caused the corporations’ effective rate of ﬁ nancing to be excessive, which strained their cash ﬂow situation. Due to the integration of Southeast Asian economies, the excessive lending by the local banks across the countries, and the susceptibility of all these countries to massive fund outﬂows, the crisis was not really focused on one country. What was initially referred to as the Thailand crisis became the Asian crisis.

Impact of the Asian Crisis on Hong Kong On October 23, 1997, prices in the Hong Kong stock market declined by 10.2 percent on average; considering the 3 trading days before that, the cumulative 4-day effect was a decline of 23.3 percent. The decline was primarily attributed to speculation that Hong Kong’s currency might be devalued and that Hong Kong could experience ﬁ nancial problems similar to the Southeast Asian countries. The fact that the market value of Hong Kong companies could decline by almost one-fourth over a 4-day period demonstrated the perceived exposure of Hong Kong to the crisis. During this period, Hong Kong maintained its pegged exchange rate system with the Hong Kong dollar tied to the U.S. dollar. However, it had to increase interest rates to discourage investors from transferring their funds out of the country.

Impact of the Asian Crisis on Russia The Asian crisis caused investors to reconsider other countries where similar effects might occur. In particular, they focused on Russia. As investors lost conﬁdence in the Russian currency (the ruble), they began to transfer funds out of Russia. In response to the downward pressure this outﬂow of funds placed on the ruble, the central bank of Russia engaged in direct intervention by using dollars to purchase rubles in the foreign exchange market. It also used indirect intervention by raising interest rates to make Russia more attractive to investors, thereby discouraging additional outﬂows. In July 1998, the IMF (with some help from Japan and the World Bank) organized a loan package worth $22.6 billion for Russia. The package required that Russia boost its tax revenue, reduce its budget deﬁcit, and create a more capitalist environment for its businesses. During August 1998, Russia’s central bank commonly intervened to prevent the ruble from declining substantially. On August 26, however, it gave up its ﬁght to defend the ruble’s value, and market forces caused the ruble to decline by more than 50 percent against most currencies on that day. This led to fears of a new crisis, and the next day (called “Bloody Thursday”), paranoia swept stock markets around the

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Impact of the Asian Crisis on South Korea By November 1997, seven of South Korea’s conglomerates (called chaebols) had collapsed. The banks that ﬁ nanced the operations of the chaebols were stuck with the equivalent of $52 billion in bad debt as a result. Like banks in the Southeast Asian countries, South Korea’s banks had been too willing to provide loans to corporations (especially the chaebols) without conducting a thorough credit analysis. The banks had apparently engaged in such risky lending because they assumed that economic growth would continue at a rapid pace and therefore exaggerated the future cash ﬂows that borrowers would have available to pay off their loans. In addition, South Korean banks had traditionally extended loans to the conglomerates without assessing whether the loans could be repaid. In November, South Korea’s currency (the won) declined substantially, and the central bank attempted to use its reserves to prevent a free fall in the won but with little success. Meanwhile, the credit ratings of several banks were downgraded because of their bad loans. On December 3, 1997, the IMF agreed to enact a $55 billion rescue package for South Korea. The World Bank and the Asian Development Bank joined with the IMF to provide a standby credit line of $35 billion. If that amount was not sufﬁcient, other countries (including Japan and the United States) had agreed to provide a credit line of $20 billion. The total available credit (assuming it was all used) exceeded the credit provided in the Mexican bailout of 1994 and made this the largest bailout ever. In exchange for the funding, South Korea agreed to reduce its economic growth and to restrict the conglomerates from excessive borrowing. This restriction resulted in some bankruptcies and unemployment, as the banks could not automatically provide loans to all conglomerates needing funds unless the funding was economically justiﬁed.

Impact of the Asian Crisis on Japan Japan was also affected by the Asian crisis because it exports products to these countries, and many of its corporations have subsidiaries in these countries so their business performance is affected by the local economic conditions. Japan had also been experiencing its own problems. Its ﬁ nancial industry had been struggling, primarily because of defaulted loans. In November 1997, one of Japan’s 20 largest banks failed. A week later, Yamaichi Securities Co. (a brokerage ﬁ rm) announced that it would shut down. Yamaichi was the largest ﬁ rm to fail in Japan since World War II. The news was shocking because the Japanese government had historically bailed out large ﬁ rms such as Yamaichi because of the possible adverse effects on other ﬁ rms. Yamaichi’s collapse made market participants question the potential failure of other large ﬁ nancial institutions that were previously perceived to be protected (“too big to fail”). The continued weakening of the Japanese yen against the U.S. dollar during the spring of 1998 put more pressure on other Asian currencies; Asian countries wanted to gain a competitive advantage in exporting to the United States as a result of their weak currencies. In April 1998, the Bank of Japan used more than $20 billion to purchase yen in the foreign exchange market. This effort to boost the yen’s value was unsuccessful. In July 1998, Prime Minister Hashimoto resigned, causing more uncertainty about the outlook for Japan.

Impact of the Asian Crisis on China Ironically, China did not experience the adverse economic effects of the Asian crisis because it had grown less rapidly than the Southeast Asian countries in the years prior

APPENDIX 6

world. Some stock markets (including the U.S. stock market) experienced declines of more than 4 percent.

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Part 2: Exchange Rate Behavior

to the crisis. The Chinese government had more control over economic conditions because it still owned most real estate and still controlled most of the banks that provided credit to support growth. Thus, there were fewer bankruptcies resulting from the crisis in China. In addition, China’s government was able to maintain the value of the yuan against the dollar, which limited speculative ﬂows of funds out of China. Though interest rates increased during the crisis, they remained relatively low. Consequently, Chinese ﬁ rms could obtain funding at a reasonable cost and could continue to meet their interest payments. Nevertheless, concerns about China mounted because it relies heavily on exports to stimulate its economy; China was now at a competitive disadvantage relative to the Southeast Asian countries whose currencies had depreciated. Thus, importers from the United States and Europe shifted some of their purchases to those countries. In addition, the decline in the other Asian currencies against the Chinese yuan encouraged Chinese consumers to purchase imports instead of locally manufactured products.

Impact of the Asian Crisis on Latin American Countries The Asian crisis also affected Latin American countries. Countries such as Chile, Mexico, and Venezuela were adversely affected because they export products to Asia, and the weak Asian economies resulted in a lower demand for the Latin American exports. In addition, the Latin American countries lost some business to other countries that switched to Asian products because of the substantial depreciation of the Asian currencies, which made their products cheaper than those of Latin America. The adverse effects on Latin American countries put pressure on Latin American currency values, as there was concern that speculative outﬂows of funds would weaken these currencies in the same way that Asian currencies had weakened. In particular, there was pressure on Brazil’s currency (the real) in late October 1997. Some speculators believed that since most Asian countries could not maintain their currencies within bands under the existing conditions, Brazil would be unable to stabilize the value of its currency. The central bank of Brazil used about $7 billion of reserves in a direct intervention to buy the real in the foreign exchange market and protect the real from depreciation. It also used indirect intervention by raising short-term interest rates in Brazil. This encouraged foreign investment in Brazil’s short-term securities to capitalize on the high interest rates and also encouraged local investors to invest locally rather than in foreign markets. The adjustment of interest rates to maintain the value of the real signaled that the central bank of Brazil was serious about maintaining the currency’s stability. The intervention was costly, however, because it increased the cost of borrowing for households, corporations, and government agencies in Brazil and thus could reduce economic growth. If Brazil’s currency had weakened, the speculative forces might have spread to the other Latin American currencies as well. The Asian crisis also caused bond ratings of many large corporations and government agencies in Latin America to be downgraded. Rumors that banks were dumping Asian bonds caused fears that all emerging market debt would be dumped in the bond markets. Furthermore, there was concern that many banks experiencing ﬁ nancial problems (because their loans were not being paid back) would sell bond holdings in the secondary market in order to raise funds. Consequently, prices of bonds issued in emerging markets declined, including those of Latin American countries.

Impact of the Asian Crisis on Europe During the Asian crisis, European countries were experiencing strong economic growth. Many European ﬁ rms, however, were adversely affected by the crisis. Like

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185

Impact of the Asian Crisis on the United States The effects of the Asian crisis were even felt in the United States. Stock values of U.S. ﬁ rms, such as 3M Co., Motorola, Hewlett-Packard, and Nike, that conducted much business in Asia declined. Many U.S. engineering and construction ﬁ rms were adversely affected as Asian countries reduced their plans to improve infrastructure. Stock values of U.S. exporters to those countries fell because of the decline in spending by consumers and corporations in Asian countries and because of the weakening of the Asian currencies, which made U.S. products more expensive. Some large U.S. commercial banks experienced signiﬁcant stock price declines because of their exposure (primarily loans and bond holdings) to Asian countries.

Lessons about Exchange Rates and Intervention The Asian crisis demonstrated the degree to which currencies could depreciate in response to a lack of conﬁdence by investors and ﬁ rms in a central bank’s ability to stabilize its local currency. If investors and ﬁ rms had believed the central banks could prevent the free fall in currency values, they would not have transferred their funds to other countries, and Southeast Asian currency values would not have experienced such downward pressure. Exhibit 6A.1 shows how exchange rates of some Asian currencies changed against the U.S. dollar during one year of the crisis (from June 1997 to June 1998). In particular, the currencies of Indonesia, Malaysia, South Korea, and Thailand declined substantially. The Asian crisis also demonstrated how interest rates could be affected by ﬂows of funds out of countries. Exhibit 6A.2 illustrates how interest rates changed from June

Exhibit 6A.1

How Exchange Rates Changed during the Asian Crisis (June 1997–June 1998)

South Korea –41% China 0% India –41% Thailand –38% Singapore –15% Indonesia –84%

Hong Kong 0%

Malaysia –37%

Taiwan –20% Philippines –37%

APPENDIX 6

ﬁ rms in Latin America, some ﬁ rms in Europe experienced a reduced demand for their exports to Asia during the crisis. In addition, they lost some exporting business to Asian exporters as a result of the weakened Asian currencies that reduced Asian prices from an importer’s perspective. European banks were especially affected by the Asian crisis because they had provided large loans to numerous Asian ﬁ rms that defaulted.

APPENDIX 6

186

Part 2: Exchange Rate Behavior Exhibit 6A.2 How Interest Rates Changed during the Asian Crisis (Number before slash represents annualized interest rate as of June 1997; number after slash represents annualized interest rate as of June 1998)

South Korea 14/17 China 8/7 Hong Kong 6/10

India 12/7 Thailand 11/24 Singapore 3/7

Taiwan 5/7 Philippines 11/14

Malaysia 7/11

Indonesia 16/47

1997 (just before the crisis) to June 1998 for various Asian countries. The increase in interest rates can be attributed to the indirect interventions intended to prevent the local currencies from depreciating further, or to the massive outﬂows of funds, or to both of these conditions. In particular, interest rates of Indonesia, Malaysia, and Thailand increased substantially from their pre-crisis levels. Those countries whose local currencies experienced more depreciation had higher upward adjustments. Since the substantial increase in interest rates (which tends to reduce economic growth) may have been caused by the outﬂow of funds, it may have been indirectly due to the lack of conﬁdence by investors and ﬁ rms in the ability of the Asian central banks to stabilize the local currencies. Finally, the Asian crisis demonstrated how integrated country economies are, especially during a crisis. Just as the U.S. and European economies can affect emerging markets, they are susceptible to conditions in emerging markets. Even if a central bank can withstand the pressure on its currency caused by conditions in other countries, it cannot necessarily insulate its economy from other countries that are experiencing ﬁ nancial problems.

DISCUSSION

QUESTIONS

The following discussion questions related to the Asian crisis illustrate how the foreign exchange market conditions are integrated with the other ﬁnancial markets around the world. Thus, participants in any of these markets must understand the dynamics of the foreign exchange market. These discussion questions can be used in

several ways. They may serve as an assignment on a day that the professor is unable to attend class. They are especially useful for group exercises. The class could be segmented into small groups; each group is asked to assess all of the issues and determine a solution. Each group should have a spokesperson. For each issue, one of the groups will

Chapter 6: Government Influence on Exchange Rates

1. Was the depreciation of the Asian currencies during the Asian crisis due to trade ﬂows or capital ﬂows? Why do you think the degree of movement over a short period may depend on whether the reason is trade ﬂows or capital ﬂows? 2. Why do you think the Indonesian rupiah was more exposed to an abrupt decline in value than the Japanese yen during the Asian crisis (even if their economies experienced the same degree of weakness)? 3. During the Asian crisis, direct intervention did not prevent depreciation of currencies. Offer your explanation for why the interventions did not work. 4. During the Asian crisis, some local ﬁ rms in Asia borrowed U.S. dollars rather than local currency to support local operations. Why would they borrow dollars when they really needed their local currency to support operations? Why did this strategy backﬁ re? 5. The Asian crisis showed that a currency crisis could affect interest rates. Why did the crisis put upward pressure on interest rates in Asian countries? Why did it put downward pressure on U.S. interest rates? 6. It is commonly argued that high interest rates reﬂect high expected inﬂation and can signal future weakness in a currency. Based on this theory, how would expectations of Asian exchange rates change after interest rates in Asia increased? Why? Is the underlying reason logical? 7. During the Asian crisis, why did the discount of the forward rate of Asian currencies change? Do you think it increased or decreased? Why? 8. During the Hong Kong crisis, the Hong Kong stock market declined substantially over a 4-day period due to concerns in the foreign exchange market. Why would stock prices decline due to concerns in the foreign exchange market? Why would some countries be more susceptible to this type of situation than others?

9. On August 26, 1998, the day that Russia decided to let the ruble ﬂoat freely, the ruble declined by about 50 percent. On the following day, called “Bloody Thursday,” stock markets around the world (including the United States) declined by more than 4 percent. Why do you think the decline in the ruble had such a global impact on stock prices? Was the markets’ reaction rational? Would the effect have been different if the ruble’s plunge had occurred in an earlier time period, such as 4 years earlier? Why? 10. Normally, a weak local currency is expected to stimulate the local economy. Yet, it appeared that the weak currencies of Asia adversely affected their economies. Why do you think the weakening of the currencies did not initially improve their economies during the Asian crisis? 11. During the Asian crisis, Hong Kong and China successfully intervened (by raising their interest rates) to protect their local currencies from depreciating. Nevertheless, these countries were also adversely affected by the Asian crisis. Why do you think the actions to protect the values of their currencies affected these countries’ economies? Why do you think the weakness of other Asian currencies against the dollar and the stability of the Chinese and Hong Kong currencies against the dollar adversely affected their economies? 12. Why do you think the values of bonds issued by Asian governments declined during the Asian crisis? Why do you think the values of Latin American bonds declined in response to the Asian crisis? 13. Why do you think the depreciation of the Asian currencies adversely affected U.S. ﬁ rms? (There are at least three reasons, each related to a different type of exposure of some U.S. ﬁ rms to exchange rate risk.) 14. During the Asian crisis, the currencies of many Asian countries declined even though their governments attempted to intervene with direct intervention or by raising interest rates. Given that the abrupt depreciation of the currencies was attributed to an abrupt outﬂow of funds in the ﬁ nancial markets, what alternative Asian government action might have been more successful in preventing a substantial decline in the currencies’ values? Are there any possible adverse effects of your proposed solution?

APPENDIX 6

be randomly selected and asked to present their solution, and then other students not in that group may suggest alternative answers if they feel that the answer can be improved. Some of the issues have no perfect solution, which allows for different points of view to be presented by students.

187

7: International Arbitrage and Interest Rate Parity If discrepancies occur within the foreign exchange market, with quoted prices of currencies varying from what the market prices should be, certain market forces will realign the rates. The realignment occurs as a result of international arbitrage. Financial managers of MNCs must understand how international arbitrage realigns exchange rates because it has implications for how they should use the foreign exchange market to facilitate their international business.

The specific objectives of this chapter are to: ■ explain the conditions that will result in various forms

of international arbitrage, along with the realignments that will occur in response to various forms of international arbitrage, and ■ explain the concept of interest rate parity and how it

prevents arbitrage opportunities.

International Arbitrage Arbitrage can be loosely deﬁ ned as capitalizing on a discrepancy in quoted prices by making a riskless proﬁt. In many cases, the strategy does not require an investment of funds to be tied up for a length of time and does not involve any risk.

Two coin shops buy and sell coins. If Shop A is willing to sell a particular coin for $120, while Shop B is willing to buy that same coin for $130, a person can execute arbitrage by purchasing the coin at Shop A for $120 and selling it to Shop B for $130. The prices at coin shops can vary because demand conditions may vary among shop locations. If two coin shops are not aware of each other’s prices, the opportunity for arbitrage may occur. ■

E X A M P L E

The act of arbitrage will cause prices to realign. In our example, arbitrage would cause Shop A to raise its price (due to high demand for the coin). At the same time, Shop B would reduce its bid price after receiving a surplus of coins as arbitrage occurs. The type of arbitrage discussed in this chapter is primarily international in scope; it is applied to foreign exchange and international money markets and takes three common forms: • Locational arbitrage • Triangular arbitrage • Covered interest arbitrage Each form will be discussed in turn.

Locational Arbitrage Commercial banks providing foreign exchange services normally quote about the same rates on currencies, so shopping around may not necessarily lead to a more

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189

favorable rate. If the demand and supply conditions for a particular currency vary among banks, the banks may price that currency at different rates, and market forces will force realignment. When quoted exchange rates vary among locations, participants in the foreign exchange market can capitalize on the discrepancy. Speciﬁ cally, they can use locational arbitrage, which is the process of buying a currency at the location where it is priced cheap and immediately selling it at another location where it is priced higher. Akron Bank and Zyn Bank serve the foreign exchange market by buying and selling currencies. Assume that there is no bid/ask spread. The exchange rate quoted at Akron Bank for a British pound is $1.60, while the exchange rate quoted at Zyn Bank is $1.61. You could conduct locational arbitrage by purchasing pounds at Akron Bank for $1.60 per pound and then selling them at Zyn Bank for $1.61 per pound. Under the condition that there is no bid/ask spread and there are no other costs to conducting this arbitrage strategy, your gain would be $.01 per pound. The gain is risk free in that you knew when you purchased the pounds how much you could sell them for. Also, you did not have to tie your funds up for any length of time. ■

E X A M P L E

Locational arbitrage is normally conducted by banks or other foreign exchange dealers whose computers can continuously monitor the quotes provided by other banks. If other banks noticed a discrepancy between Akron Bank and Zyn Bank, they would quickly engage in locational arbitrage to earn an immediate risk-free proﬁt. Since banks have a bid/ask spread on currencies, this next example accounts for the spread. The information on British pounds at both banks is revised to include the bid/ask spread in Exhibit 7.1. Based on these quotes, you can no longer profit from locational arbitrage. If you buy pounds from Akron Bank at $1.61 (the bank’s ask price) and then sell the pounds at Zyn Bank at its bid price of $1.61, you just break even. As this example demonstrates, even when the bid or ask prices of two banks are different, locational arbitrage will not always be possible. To achieve profits from locational arbitrage, the bid price of one bank must be higher than the ask price of another bank. ■

E X A M P L E

Gains from Locational Arbitrage. Your gain from locational arbitrage is based on the amount of money that you use to capitalize on the exchange rate discrepancy, along with the size of the discrepancy. The quotations for the New Zealand dollar (NZ$) at two banks are shown in Exhibit 7.2. You can obtain New Zealand dollars from North Bank at the ask price of $.640 and then sell New Zealand dollars to South Bank at the bid price of $.645. This represents one “roundtrip” transaction in locational arbitrage. If you start with $10,000 and conduct one round-trip transaction, how many U.S. dollars will you end up with? The $10,000 is initially exchanged for NZ$15,625 ($10,000/$.640 per New Zealand dollar) at North Bank. Then the NZ$15,625 are sold for $.645 each, for a total of $10,078. Thus, your gain from locational arbitrage is $78. ■

E X A M P L E

Your gain may appear to be small relative to your investment of $10,000. However, consider that you did not have to tie up your funds. Your round-trip transaction could Exhibit 7.1

Currency Quotes for Locational Arbitrage Example Akron Bank

British pound quote

Bid

Ask

$1.60

$1.61

Zyn Bank

British pound quote

Bid

Ask

$1.61

$1.62

Part 2: Exchange Rate Behavior Locational Arbitrage

Ask $.640

South Bank Bid NZ$ quote $.645

Ask $.650

$

NZ

$

$

North Bank Bid NZ$ quote $.635

$

Exhibit 7.2

NZ

190

Foreign Exchange Market Participants Summary of Locational Arbitrage

Step 1: Use U.S.$ to buy NZ$ for $.640 at North Bank. Step 2: Take the NZ$ purchased from North Bank and sell them to South Bank in exchange for U.S. dollars.

take place over a telecommunications network within a matter of seconds. Also, if you could use a larger sum of money for the transaction, your gains would be larger. Finally, you could continue to repeat your round-trip transactions until North Bank’s ask price is no longer less than South Bank’s bid price. This example is not intended to suggest that you can pay for your education through part-time locational arbitrage. As mentioned earlier, foreign exchange dealers compare quotes from banks on computer terminals, which immediately signal any opportunity to employ locational arbitrage.

Realignment due to Locational Arbitrage. Quoted prices will react to the locational arbitrage strategy used by you and other foreign exchange market participants. In the previous example, the high demand for New Zealand dollars at North Bank (resulting from arbitrage activity) will cause a shortage of New Zealand dollars there. As a result of this shortage, North Bank will raise its ask price for New Zealand dollars. The excess supply of New Zealand dollars at South Bank (resulting from sales of New Zealand dollars to South Bank in exchange for U.S. dollars) will force South Bank to lower its bid price. As the currency prices are adjusted, gains from locational arbitrage will be reduced. Once the ask price of North Bank is not any lower than the bid price of South Bank, locational arbitrage will no longer occur. Prices may adjust in a matter of seconds or minutes from the time when locational arbitrage occurs. ■

E X A M P L E

The concept of locational arbitrage is relevant in that it explains why exchange rate quotations among banks at different locations normally will not differ by a signiﬁcant amount. This applies not only to banks on the same street or within the same city but to all banks across the world. Technology allows banks to be electronically connected to foreign exchange quotations at any time. Thus, banks can ensure that their quotes are in line with those of other banks. They can also immediately detect any discrepancies among quotations as soon as they occur, and capitalize on

Chapter 7: International Arbitrage and Interest Rate Parity

H T T P : // http://ﬁnance.yahoo.com/ currency?u Currency converter for over 100 currencies with frequent daily foreign exchange rate updates.

191

those discrepancies. Thus, technology enables more consistent prices among banks and reduces the likelihood of signiﬁcant discrepancies in foreign exchange quotations among locations.

Triangular Arbitrage Cross exchange rates represent the relationship between two currencies that are

different from one’s base currency. In the United States, the term cross exchange rate refers to the relationship between two nondollar currencies.

E X A M P L E

If the British pound (£) is worth $1.60, while the Canadian dollar (C$) is worth $.80, the value of the British pound with respect to the Canadian dollar is calculated as follows:

Value of £ in units of C$ $1.60/$.80 2.0 The value of the Canadian dollar in units of pounds can also be determined from the cross exchange rate formula:

Value of C$ in units of £ $.80/$1.60 .50 Notice that the value of a Canadian dollar in units of pounds is simply the reciprocal of the value of a pound in units of Canadian dollars. ■

If a quoted cross exchange rate differs from the appropriate cross exchange rate (as determined by the preceding formula), you can attempt to capitalize on the discrepancy. Speciﬁcally, you can use triangular arbitrage in which currency transactions are conducted in the spot market to capitalize on a discrepancy in the cross exchange rate between two currencies. Assume that a bank has quoted the British pound (£) at $1.60, the Malaysian ringgit (MYR) at $.20, and the cross exchange rate at £1 MYR8.1. Your first task is to use the pound value in U.S. dollars and Malaysian ringgit value in U.S. dollars to develop the cross exchange rate that should exist between the pound and the Malaysian ringgit. The cross rate formula in the previous example reveals that the pound should be worth MYR8.0. When quoting a cross exchange rate of £1 MYR8.1, the bank is exchanging too many ringgit for a pound and is asking for too many ringgit in exchange for a pound. Based on this information, you can engage in triangular arbitrage by purchasing pounds with dollars, converting the pounds to ringgit, and then exchanging the ringgit for dollars. If you have $10,000, how many dollars will you end up with if you implement this triangular arbitrage strategy? To answer the question, consider the following steps illustrated in Exhibit 7.3:

E X X A M P L E

1. Determine the number of pounds received for your dollars: $10,000 £6,250, based on the bank’s quote of $1.60 per pound. 2. Determine how many ringgit you will receive in exchange for pounds: £6,250 MYR50,625, based on the bank’s quote of 8.1 ringgit per pound. 3. Determine how many U.S. dollars you will receive in exchange for the ringgit: MYR50,625 $10,125 based on the bank’s quote of $.20 per ringgit (5 ringgit to the dollar). The triangular arbitrage strategy generates $10,125, which is $125 more than you started with. ■

Like locational arbitrage, triangular arbitrage does not tie up funds. Also, the strategy is risk free since there is no uncertainty about the prices at which you will buy and sell the currencies.

Accounting for the Bid/Ask Spread. The previous example is simpliﬁed in that it does not account for transaction costs. In reality, there is a bid and ask quote for each currency, which means that the arbitrageur incurs transaction costs

192

Part 2: Exchange Rate Behavior

that can reduce or even eliminate the gains from triangular arbitrage. The following example illustrates how bid and ask prices can affect arbitrage proﬁts. Using the quotations in Exhibit 7.4, you can determine whether triangular arbitrage is possible by starting with some fictitious amount (say, $10,000) of U.S. dollars and estimating the number of dollars you would generate by implementing the strategy. Exhibit 7.4 differs from the previous example only in that bid/ask spreads are now considered. Recall that the previous triangular arbitrage strategy involved exchanging dollars for pounds, pounds for ringgit, and then ringgit for dollars. Apply this strategy to the bid and ask quotations in Exhibit 7.4. The steps are summarized in Exhibit 7.5.

E X A M P L E

Step 1. Your initial $10,000 will be converted into approximately £6,211 (based on the bank’s ask price of $1.61 per pound). Step 2. Then the £6,211 are converted into MYR50,310 (based on the bank’s bid price for pounds of MYR8.1 per pound, £6,211 8.1 MYR50,310). Step 3. The MYR50,310 are converted to $10,062 (based on the bank’s bid price of $.200). The profit is $10,062 $10,000 $62. The profit is lower here than in the previous example because bid and ask quotations are used. ■ Example of Triangular Arbitrage

U.S. Dollar ($)

Ste

xch (M ange YR 50 MYR ,62 fo 5 r$ $1 at $ 0,1 .20 25 pe ) rM

YR

Exhibit 7.3

Ste

£

p3

er

:E

0p

1.6 t$ £ a 0) or ,25 $ f £6 ge an 00 xch ,0 : E ($10

p1

Malaysian Ringgit (MYR)

Exhibit 7.4

Step 2: Exchange £ for MYR at MYR8.1 per £ (£6,250 MYR50,625)

British Pound (£)

Currency Quotes for a Triangular Arbitrage Example Quoted Bid Price

Quoted Ask Price

Value of a British pound in U.S. dollars

$1.60

$1.61

Value of a Malaysian ringgit (MYR) in U.S. dollars

$.200

$.201

Value of a British pound in Malaysian ringgit (MYR)

MYR8.10

MYR8.20

Chapter 7: International Arbitrage and Interest Rate Parity

193

Realignment Due to Triangular Arbitrage. The realignment that results from the triangular arbitrage activity is summarized in the second column of Exhibit 7.6. The realignment will likely occur quickly to prevent continued beneﬁts from triangular arbitrage. The discrepancies assumed here are unlikely to occur within a single bank. More likely, triangular arbitrage would require three transactions at three separate banks. If any two of these three exchange rates are known, the exchange rate of the third pair can be determined. When the actual cross exchange rate differs from the appropriate cross exchange rate, the exchange rates of the currencies are not in equilibrium. Triangular arbitrage would force the exchange rates back into equilibrium. Like locational arbitrage, triangular arbitrage is a strategy that few of us can ever take advantage of because the computer technology available to foreign exchange dealers can easily detect misalignments in cross exchange rates. The point of this discussion is that triangular arbitrage will ensure that cross exchange rates are usually aligned correctly. If cross exchange rates are not properly aligned, triangular arbitrage will take place until the rates are aligned correctly.

Example of Triangular Arbitrage Accounting for Bid/Ask Spreads

U.S. Dollar ($)

Ste

£

p3

er

:E

1p

1.6 t$ £ a 1) or ,21 $ f £6 ge an 00 xch ,0 : E ($10 p1 Ste

xch (M ange YR 50 MYR ,31 fo 0 r$ $1 at $ 0,0 .20 62 pe ) rM

YR

Exhibit 7.5

Malaysian Ringgit (MYR)

Exhibit 7.6

Step 2: Exchange £ for MYR at MYR8.1 per £ (£6,211 MYR50,310)

British Pound (£)

Impact of Triangular Arbitrage

Activity

Impact

1. Participants use dollars to purchase pounds.

Bank increases its ask price of pounds with respect to the dollar.

2. Participants use pounds to purchase Malaysian ringgit.

Bank reduces its bid price of the British pound with respect to the ringgit; that is, it reduces the number of ringgit to be exchanged per pound received.

3. Participants use Malaysian ringgit to purchase U.S. dollars.

Bank reduces its bid price of ringgit with respect to the dollar.

194

Part 2: Exchange Rate Behavior

Covered Interest Arbitrage The forward rate of a currency for a speciﬁed future date is determined by the interaction of demand for the contract (forward purchases) versus the supply (forward sales). Forward rates are quoted for some widely traded currencies (just below the respective spot rate quotation) in the Wall Street Journal. Financial institutions that offer foreign exchange services set the forward rates, but these rates are driven by the market forces (demand and supply conditions). In some cases, the forward rate may be priced at a level that allows investors to engage in arbitrage. Their actions will affect the volume of orders for forward purchases or forward sales of a particular currency, which in turn will affect the equilibrium forward rate. Arbitrage will continue until the rate is aligned where it should be, and at that point arbitrage will no longer be feasible. This arbitrage process and its effects on the forward rate are described next. Covered interest arbitrage is the process of capitalizing on the interest rate differential between two countries while covering your exchange rate risk with a forward contract. The logic of the term covered interest arbitrage becomes clear when it is broken into two parts: “interest arbitrage” refers to the process of capitalizing on the difference between interest rates between two countries; “covered” refers to hedging your position against exchange rate risk. Covered interest arbitrage is sometimes interpreted to mean that the funds to be invested are borrowed locally. In this case, the investors are not tying up any of their own funds. In another interpretation, however, the investors use their own funds. In this case, the term arbitrage is loosely deﬁ ned since there is a positive dollar amount invested over a period of time. The following discussion is based on this latter meaning of covered interest arbitrage; under either interpretation, however, arbitrage should have a similar impact on currency values and interest rates. You desire to capitalize on relatively high rates of interest in the United Kingdom and have funds available for 90 days. The interest rate is certain; only the future exchange rate at which you will exchange pounds back to U.S. dollars is uncertain. You can use a forward sale of pounds to guarantee the rate at which you can exchange pounds for dollars at a future point in time. This actual strategy is as follows:

E X A M P L E

1. On day 1, convert your U.S. dollars to pounds and set up a 90-day deposit account in a British bank. 2. On day 1, engage in a forward contract to sell pounds 90 days forward. 3. In 90 days when the deposit matures, convert the pounds to U.S. dollars at the rate that was agreed upon in the forward contract. ■

If the proceeds from engaging in covered interest arbitrage exceed the proceeds from investing in a domestic bank deposit, and assuming neither deposit is subject to default risk, covered interest arbitrage is feasible. The feasibility of covered interest arbitrage is based on the interest rate differential and the forward rate premium. To illustrate, consider the following numerical example.

E X A M P L E

Assume the following information:

• You have $800,000 to invest. • The current spot rate of the pound is $1.60. • The 90-day forward rate of the pound is $1.60. • The 90-day interest rate in the United States is 2 percent. • The 90-day interest rate in the United Kingdom is 4 percent.

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195

Based on this information, you should proceed as follows: 1. On day 1, convert the $800,000 to £500,000 and deposit the £500,000 in a British bank. 2. On day 1, sell £520,000 90 days forward. By the time the deposit matures, you will have £520,000 (including interest). 3. In 90 days when the deposit matures, you can fulfill your forward contract obligation by converting your £520,000 into $832,000 (based on the forward contract rate of $1.60 per pound). ■

This act of covered interest arbitrage is illustrated in Exhibit 7.7. It results in a 4 percent return over the 3-month period, which is 2 percent above the return on a U.S. deposit. In addition, the return on this foreign deposit is known on day 1, since you know when you make the deposit exactly how many dollars you will get back from your 90-day investment. Recall that locational and triangular arbitrage do not tie up funds; thus, any profits are achieved instantaneously. In the case of covered interest arbitrage, the funds are tied up for a period of time (90 days in our example). This strategy would not be advantageous if it earned 2 percent or less, since you could earn 2 percent on a domestic deposit. The term arbitrage here suggests that you can guarantee a return on your funds that exceeds the returns you could achieve domestically.

Realignment Due to Covered Interest Arbitrage. As with the other forms of arbitrage, market forces resulting from covered interest arbitrage will cause a market realignment. As many investors capitalize on covered interest arbitrage, there is upward pressure on the spot rate and downward pressure on the 90-day forward rate. Once the forward rate has a discount from the spot rate that is about equal to the interest rate advantage, covered interest arbitrage will no longer be feasible. Since the interest rate advantage of the British interest rate over the U.S. Exhibit 7.7

Example of Covered Interest Arbitrage

Day 1: Exchange $800,000 for £500,000

Investor

Day 1: Lock in Forward Sale of £520,000 for 90 Days Ahead

Banks That Provide Foreign Exchange

Day 90: Exchange £520,000 for $832,000

Day 1: Invest £500,000 in Deposit Earning 4%

Summary Initial Investment $800,000 Amount Received in 90 Days $832,000 Return over 90 Days 4%

British Deposit

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Part 2: Exchange Rate Behavior

interest rate is 2 percent, the arbitrage will no longer be feasible once the forward rate of the pound exhibits a discount of about 2 percent. Assume that as a result of covered interest arbitrage, the market forces caused the spot rate of the pound to rise to $1.62 and that the 90-day forward rate of the pound declined to $1.5888. Consider the results from using $800,000 (as in the previous example) to engage in covered interest arbitrage.

E X A M P L E

1. Convert $800,000 to pounds:

$800,000/$1.62 £493,827 2. Calculate accumulated pounds over 90 days at 4 percent:

£493,827 1.04 £513,580 3. Reconvert pounds to dollars (at the forward rate of $1.5888) after 90 days:

£513,580 $1.5888 $815,976 4. Determine the yield earned from covered interest arbitrage:

($815,976 $800,000)/$800,000 .02, or 2% As this example shows, those individuals who initially conduct covered interest arbitrage cause exchange rates and possibly interest rates to move in such a way that future attempts at covered interest arbitrage provide a return that is no better than what is possible domestically. Due to the market forces from covered interest arbitrage, a relationship between the forward rate premium and interest rate differentials should exist. This relationship is discussed shortly. ■

Consideration of Spreads. One more example is provided to illustrate the effects of the spread between the bid and ask quotes and the spread between deposit and loan rates. E X A M P L E

The following exchange rates and one-year interest rates exist.

Bid Quote

Ask Quote

$1.12

$1.13

1.12

1.13

Deposit Rate

Loan Rate

Interest rate on dollars

6.0%

9.0%

Interest rate on euros

6.5%

9.5%

Euro spot Euro one-year forward

You have $100,000 to invest for one year. Would you benefit from engaging in covered interest arbitrage? Notice that the quotes of the euro spot and forward rates are exactly the same, while the deposit rate on euros is .5 percent higher than the deposit rate on dollars. So it may seem that covered interest arbitrage is feasible. However, U.S. investors would be subjected to the ask quote when buying euros (€) in the spot market, versus the bid quote when selling the euros through a one-year forward contract. 1. Convert $100,000 to euros (ask quote):

$100,000/$1.13 €88,496

Chapter 7: International Arbitrage and Interest Rate Parity

197

2. Calculate accumulated euros over one year at 6.5 percent:

€88,496 1.065 €94,248 3. Sell euros for dollars at the forward rate (bid quote):

€94,248 $1.12 $105,558 4. Determine the yield earned from covered interest arbitrage:

($105,558 $100,000)/$100,000 .05558, or 5.558% The yield is less than you would have earned if you had invested the funds in the United States. Thus, covered interest arbitrage is not feasible. ■

Comparison of Arbitrage Effects Exhibit 7.8 provides a comparison of the three types of arbitrage. The threat of locational arbitrage ensures that quoted exchange rates are similar across banks in different locations. The threat of triangular arbitrage ensures that cross exchange rates are properly set. The threat of covered interest arbitrage ensures that forward exchange rates are properly set. Any discrepancy will trigger arbitrage, which should eliminate the discrepancy. Thus, arbitrage tends to allow for a more orderly foreign exchange market. Exhibit 7.8

Comparing Arbitrage Strategies

Locational Arbitrage: Capitalizes on discrepancies in exchange rates across locations.

Value of £ Quoted in Dollars by a U.S. Bank

Value of £ Quoted in Dollars by a British Bank

Triangular Arbitrage: Capitalizes on discrepancies in cross exchange rates.

Value of £ Quoted in Euros

Value of £ Quoted in Dollars

Value of Euro Quoted in Dollars

Covered Interest Arbitrage: Capitalizes on discrepancies between the forward rate and the interest rate differential.

Forward Rate of £ Quoted in Dollars

Interest Rate Differential Between U.S. and British Interest Rates

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Part 2: Exchange Rate Behavior

Interest Rate Parity (IRP) Once market forces cause interest rates and exchange rates to adjust such that covered interest arbitrage is no longer feasible, there is an equilibrium state referred to as interest rate parity (IRP). In equilibrium, the forward rate differs from the spot rate by a sufﬁcient amount to offset the interest rate differential between two currencies. In the previous example, the U.S. investor receives a higher interest rate from the foreign investment, but there is an offsetting effect because the investor must pay more per unit of foreign currency (at the spot rate) than is received per unit when the currency is sold forward (at the forward rate). Recall that when the forward rate is less than the spot rate, this implies that the forward rate exhibits a discount.

Derivation of Interest Rate Parity The relationship between a forward premium (or discount) of a foreign currency and the interest rates representing these currencies according to IRP can be determined as follows. Consider a U.S. investor who attempts covered interest arbitrage. The investor’s return from using covered interest arbitrage can be determined given the following: • The amount of the home currency (U.S. dollars in our example) that is initially invested (A h). • The spot rate (S) in dollars when the foreign currency is purchased. • The interest rate on the foreign deposit (if). • The forward rate (F) in dollars at which the foreign currency will be converted back to U.S. dollars. The amount of the home currency received at the end of the deposit period due to such a strategy (called An) is: An 5 1 Ah /S 2 1 1 1 if 2 F

Since F is simply S times one plus the forward premium (called p), we can rewrite this equation as: An 5 1 Ah /S 2 1 1 1 if 2 3 S 1 1 1 p 2 4 5 Ah 1 1 1 if 2 1 1 1 p 2 The rate of return from this investment (called R) is as follows: R5 5

An 2 Ah Ah 3 Ah 1 1 1 if 2 1 1 1 p 2 4 2 Ah Ah

5 1 1 1 if 2 1 1 1 p 2 2 1 If IRP exists, then the rate of return achieved from covered interest arbitrage (R) should be equal to the rate available in the home country. Set the rate that can be achieved from using covered interest arbitrage equal to the rate that can be achieved from an investment in the home country (the return on a home investment is simply the home interest rate called ih): R ih By substituting into the formula the way in which R is determined, we obtain: 1 1 1 if 2 1 1 1 p 2 2 1 5 ih

Chapter 7: International Arbitrage and Interest Rate Parity

199

By rearranging terms, we can determine what the forward premium of the foreign currency should be under conditions of IRP: 1 1 1 if 2 1 1 1 p 2 2 1 5 ih 1 1 1 if 2 1 1 1 p 2 5 1 1 ih 11p5 p5

1 1 ih 1 1 if 1 1 ih 1 1 if

21

Thus, given the two interest rates of concern, the forward rate under conditions of IRP can be derived. If the actual forward rate is different from this derived forward rate, there may be potential for covered interest arbitrage.

Determining the Forward Premium Using the information just presented, the forward premium can be measured based on the interest rate differential under conditions of IRP. Assume that the Mexican peso exhibits a 6-month interest rate of 6 percent, while the U.S. dollar exhibits a 6-month interest rate of 5 percent. From a U.S. investor’s perspective, the U.S. dollar is the home currency. According to IRP, the forward rate premium of the peso with respect to the U.S. dollar should be:

E X X A M P L E

p5

1 1 .05 1 1 .06

21

5 2.0094, or 2.94% 1 not annualized 2 Thus, the peso should exhibit a forward discount of about .94 percent. This implies that U.S. investors would receive .94 percent less when selling pesos 6 months from now (based on a forward sale) than the price they pay for pesos today at the spot rate. Such a discount would offset the interest rate advantage of the peso. If the peso’s spot rate is $.10, a forward discount of .94 percent means that the 6-month forward rate is as follows:

F 5 S11 1 p2 5 $.10 1 1 2 .0094 2 5 $.09906

■

Relationship between Forward Premium and Interest Rate Differential. The relationship between the forward premium (or discount) and the interest rate differential according to IRP is simpliﬁed in an approximated form as follows: p5

F2S > ih 2 if S

where p F S ih if

forward premium (or discount) forward rate in dollars spot rate in dollars home interest rate foreign interest rate

This approximated form provides a reasonable estimate when the interest rate differential is small. The variables in this equation are not annualized. In our previous example, the U.S. (home) interest rate is less than the foreign interest rate, so the

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Part 2: Exchange Rate Behavior

forward rate contains a discount (the forward rate is less than the spot rate). The larger the degree by which the foreign interest rate exceeds the home interest rate, the larger will be the forward discount of the foreign currency speciﬁed by the IRP formula. If the foreign interest rate is less than the home interest rate, the IRP relationship suggests that the forward rate should exhibit a premium.

Implications. If the forward premium is equal to the interest rate differential as explained above, covered interest arbitrage will not be feasible. Use the information on the spot rate, the 6-month forward rate of the peso, and Mexico’s interest rate from the preceding example to determine a U.S. investor’s return from using covered interest arbitrage. Assume the investor begins with $1,000,000 to invest.

E X A M P L E

Step 1. On the first day, the U.S. investor converts $1,000,000 into Mexican pesos (MXP) at $.10 per peso:

$1,000,000/$.10 per peso MXP10,000,000 Step 2. On the first day, the U.S. investor also sells pesos 6 months forward. The number of pesos to be sold forward is the anticipated accumulation of pesos over the 6-month period, which is estimated as:

MXP10,000,000 (1 .06) MXP10,600,000 Step 3. After 6 months, the U.S. investor withdraws the initial deposit of pesos along with the accumulated interest, amounting to a total of 10,600,000 pesos. The investor converts the pesos into dollars in accordance with the forward contract agreed upon 6 months earlier. The forward rate was $.09906, so the number of U.S. dollars received from the conversion is:

MXP10,600,000 ($.09906 per peso) $1,050,036 In this case, the investor’s covered interest arbitrage achieves a return of about 5 percent. Rounding the forward discount to .94 percent causes the slight deviation from the 5 percent return. The results suggest that, in this instance, using covered interest arbitrage generates a return that is about what the investor would have received anyway by simply investing the funds domestically. This confirms that covered interest arbitrage is not worthwhile if IRP exists. ■

Graphic Analysis of Interest Rate Parity H T T P : // http://www.bloomberg.com Latest information from ﬁnancial markets around the world.

The interest rate differential can be compared to the forward premium (or discount) with the use of a graph. All the possible points that represent interest rate parity are plotted on Exhibit 7.9 by using the approximation expressed earlier and plugging in numbers.

Points Representing a Discount. For all situations in which the foreign interest rate exceeds the home interest rate, the forward rate should exhibit a discount approximately equal to that differential. When the foreign interest rate (if) exceeds the home interest rate (ih) by 1 percent (ih if 1%), then the forward rate should exhibit a discount of 1 percent. This is represented by point A on the graph. If the foreign interest rate exceeds the home rate by 2 percent, then the forward rate should exhibit a discount of 2 percent, as represented by point B on the graph, and so on. Points Representing a Premium. For all situations in which the foreign interest rate is less than the home interest rate, the forward rate should exhibit a premium approximately equal to that differential. For example, if the home interest

Chapter 7: International Arbitrage and Interest Rate Parity Exhibit 7.9

201

Illustration of Interest Rate Parity

ih – if (%) IRP Line

3 Y

D 1 Forward Discount (%)

–5

–1 A

Z

–1

C 3

5

Forward Premium (%)

B X

–3

rate exceeds the foreign rate by 1 percent (ih if 1%), then the forward premium should be 1 percent, as represented by point C. If the home interest rate exceeds the foreign rate by 2 percent (ih if 2%), then the forward premium should be 2 percent, as represented by point D, and so on.

Points Representing IRP. Any points lying on the diagonal line cutting the intersection of the axes represent IRP. For this reason, that diagonal line is referred to as the interest rate parity (IRP) line. Covered interest arbitrage is not possible for points along the IRP line. An individual or corporation can at any time examine all currencies to compare forward rate premiums (or discounts) to interest rate differentials. From a U.S. perspective, interest rates in Japan are usually lower than the home interest rates. Consequently, the forward rate of the Japanese yen usually exhibits a premium and may be represented by points such as C or D or even points above D along the diagonal line in Exhibit 7.9. Conversely, the United Kingdom often has higher interest rates than the United States, so the pound’s forward rate often exhibits a discount, represented by point A or B. Exhibit 7.9 can be used whether or not you annualize the rates, as long as you are consistent. That is, if you annualize the interest rates to determine the interest rate differential, you should also annualize the forward premium or discount. Points below the IRP Line. What if a 3-month deposit represented by a foreign currency offers an annualized interest rate of 10 percent versus an annualized interest rate of 7 percent in the home country? Such a scenario is represented on the graph by ih if 3%. Also assume that the foreign currency exhibits an annualized forward discount of 1 percent. The combined interest rate differential and forward discount information can be represented by point X on the graph. Since point X is not on the IRP line, we should expect that covered interest arbitrage will be beneﬁ cial for some investors. The investor attains an additional 3 percentage points for the

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Part 2: Exchange Rate Behavior

foreign deposit, and this advantage is only partially offset by the 1 percent forward discount. Assume that the annualized interest rate for the foreign currency is 5 percent, as compared to 7 percent for the home country. The interest rate differential expressed on the graph is ih if 2%. However, assume that the forward premium of the foreign currency is 4 percent (point Y in Exhibit 7.9). Thus, the high forward premium more than makes up what the investor loses on the lower interest rate from the foreign investment. If the current interest rate and forward rate situation is represented by point X or Y, home country investors can engage in covered interest arbitrage. By investing in a foreign currency, they will earn a higher return (after considering the foreign interest rate and forward premium or discount) than the home interest rate. This type of activity will place upward pressure on the spot rate of the foreign currency, and downward pressure on the forward rate of the foreign currency, until covered interest arbitrage is no longer feasible.

Points above the IRP Line. Now shift to the left side of the IRP line. Take point Z, for example. This represents a foreign interest rate that exceeds the home interest rate by 1 percent, while the forward rate exhibits a 3 percent discount. This point, like all points to the left of the IRP line, represents a situation in which U.S. investors would achieve a lower return on a foreign investment than on a domestic one. This lower return normally occurs either because (1) the advantage of the foreign interest rate relative to the U.S. interest rate is more than offset by the forward rate discount (reﬂected by point Z), or because (2) the degree by which the home interest rate exceeds the foreign rate more than offsets the forward rate premium. For points such as these, however, covered interest arbitrage is feasible from the perspective of foreign investors. Consider British investors in the United Kingdom, whose interest rate is 1 percent higher than the U.S. interest rate, and the forward rate (with respect to the dollar) contains a 3 percent discount (as represented by point Z). British investors will sell their foreign currency in exchange for dollars, invest in dollar-denominated securities, and engage in a forward contract to purchase pounds forward. Though they earn 1 percent less on the U.S. investment, they are able to purchase their home currency forward for 3 percent less than what they initially sold it forward in the spot market. This type of activity will place downward pressure on the spot rate of the pound and upward pressure on the pound’s forward rate, until covered interest arbitrage is no longer feasible.

How to Test Whether Interest Rate Parity Exists An investor or ﬁ rm can plot all realistic points for various currencies on a graph such as that in Exhibit 7.9 to determine whether gains from covered interest arbitrage can be achieved. The location of the points provides an indication of whether covered interest arbitrage is worthwhile. For points to the right of the IRP line, investors in the home country should consider using covered interest arbitrage, since a return higher than the home interest rate (ih) is achievable. Of course, as investors and ﬁ rms take advantage of such opportunities, the point will tend to move toward the IRP line. Covered interest arbitrage should continue until the interest rate parity relationship holds.

Interpretation of Interest Rate Parity Interest rate parity does not imply that investors from different countries will earn the same returns. It is focused on the comparison of a foreign investment and a domestic investment in risk-free interest-bearing securities by a particular investor.

Chapter 7: International Arbitrage and Interest Rate Parity

203

Assume that the United States has a 10 percent interest rate, while the United Kingdom has a 14 percent interest rate. U.S. investors can achieve 10 percent domestically or attempt to use covered interest arbitrage. If they attempt covered interest arbitrage while IRP exists, then the result will be a 10 percent return, the same as they could achieve in the United States. If British investors attempt covered interest arbitrage while IRP exists, then the result will be a 14 percent return, the same as they could achieve in the United Kingdom. Thus, U.S. investors and British investors do not achieve the same nominal return here, even though IRP exists. An appropriate summary explanation of IRP is that if IRP exists, investors cannot use covered interest arbitrage to achieve higher returns than those achievable in their respective home countries. ■

E X A M P L E

Does Interest Rate Parity Hold? To determine conclusively whether interest rate parity holds, it is necessary to compare the forward rate (or discount) with interest rate quotations occurring at the same time. If the forward rate and interest rate quotations do not reﬂect the same time of day, then results could be somewhat distorted. Due to limitations in access to data, it is difﬁcult to obtain quotations that reﬂect the same point in time. A comparison of annualized forward rate premiums and annualized interest rate differentials for ﬁve widely traded currencies as of April 13, 2007, is provided in Exhibit 7.10 from a U.S. perspective. At this time, the U.S. interest rate was higher than the Japanese and German interest rates and lower than the interest rates in the other countries. The exhibit shows that the yen and euro (Germany’s currency) exhibited a forward premium, while all other currencies exhibited a discount. The Australian dollar exhibited the most pronounced forward discount, which is attributed to its

Exhibit 7.10

Forward Rate Premiums and Interest Rate Differentials for Five Currencies

6

iU.S. if

Japan 4

2 Germany Forward Discount

6

4

2

Brazil

Australia

U.K.

2

4

6

Forward Premium

2

4

6 Note: The data are as of April 13, 2007. The forward rate premium is based on the 6-month forward rate and is annualized. The interest rate differential represents the difference between the 6-month annualized U.S. interest rate and the 6-month foreign interest rate.

204

Part 2: Exchange Rate Behavior

relatively high interest rate. The forward premium or discount of each currency is in line with the interest rate differential and therefore reﬂects IRP. At different points in time, the position of a country may change. For example, if Brazil’s interest rate increased while other countries’ interest rates stayed the same, Brazil’s position would move down along the y axis. Yet, its forward discount would likely be more pronounced (farther to the left along the x axis) as well, since covered interest arbitrage would occur otherwise. Therefore, its new point would be farther to the left but would still be along the 45-degree line. Numerous academic studies have conducted empirical examination of IRP in several periods. The actual relationship between the forward rate premium and interest rate differentials generally supports IRP. Although there are deviations from IRP, they are often not large enough to make covered interest arbitrage worthwhile, as we will now discuss in more detail.

Considerations When Assessing Interest Rate Parity If interest rate parity does not hold, covered interest arbitrage deserves consideration. Nevertheless, covered interest arbitrage still may not be worthwhile due to various characteristics of foreign investments, including transaction costs, political risk, and differential tax laws.

Transaction Costs. If an investor wishes to account for transaction costs, the actual point reﬂecting the interest rate differential and forward rate premium must be farther from the IRP line to make covered interest arbitrage worthwhile. Exhibit 7.11 identiﬁes the areas that reﬂect potential for covered interest arbitrage after accounting for transaction costs. Notice the band surrounding the IRP line. For points not on the IRP line but within this band, covered interest arbitrage is not worthwhile (because the excess return is offset by costs). For points to the right of (or below) the band, investors residing in the home country could gain through covered Exhibit 7.11

Potential for Covered Interest Arbitrage When Considering Transaction Costs

ih – if (%) IRP Line Zone of Potential Covered Interest Arbitrage by Foreign Investors Forward Discount (%)

–4

–2 –2 –4

Zone Where Covered Interest Arbitrage Is Not Feasible

4 2

2 4 Zone of Potential Covered Interest Arbitrage by Investors Residing in the Home Country

Forward Premium (%)

Chapter 7: International Arbitrage and Interest Rate Parity

205

interest arbitrage. For points to the left of (or above) the band, foreign investors could gain through covered interest arbitrage.

Political Risk. Even if covered interest arbitrage appears feasible after accounting for transaction costs, investing funds overseas is subject to political risk. Though the forward contract locks in the rate at which the foreign funds should be reconverted, there is no guarantee that the foreign government will allow the funds to be reconverted. A crisis in the foreign country could cause its government to restrict any exchange of the local currency for other currencies. In this case, the investor would be unable to use these funds until the foreign government eliminated the restriction. Investors may also perceive a slight default risk on foreign investments such as foreign Treasury bills, since they may not be assured that the foreign government will guarantee full repayment of interest and principal upon default. Therefore, because of concern that the foreign Treasury bills may default, they may accept a lower interest rate on their domestic Treasury bills rather than engage in covered interest arbitrage in an effort to obtain a slightly higher expected return.

Differential Tax Laws. Because tax laws vary among countries, investors and ﬁ rms that set up deposits in other countries must be aware of the existing tax laws. Covered interest arbitrage might be feasible when considering before-tax returns but not necessarily when considering after-tax returns. Such a scenario would be due to differential tax rates.

Forward Premiums across Maturity Markets The yield curve represents the relationship between the annualized yield of risk-free debt and the time to maturity at a given point in time. The shape of the yield curve in the United States commonly has an upward slope, implying that the annualized interest rate is higher for longer terms to maturity. The yield curve of every country has its own unique shape. Consequently, the annualized interest rate differential between two countries can vary among debt maturities, and so will the annualized forward premiums. To illustrate, review Exhibit 7.12, which shows today’s quoted interest rates for various times to maturity. If you plot a yield curve with the time to maturity on the horizontal axis and the U.S. interest rate on the vertical axis, the U.S. yield curve today is upward sloping. If you repeat the exercise for the interest rate of the euro, the yield curve is ﬂat, as the annualized interest rate in the euro zone is the same regardless of the maturity. For times to maturity of less than 180 days, the euro interest rate is higher than the U.S. interest rate, so the forward rate of the euro would exhibit a discount if IRP holds. For the time to maturity of 180 days, the euro interest rate is equal to the U.S. interest rate, which means that the 180-day forward rate of the euro Exhibit 7.12

Quoted Interest Rates for Various Times to Maturity Approximate Forward Rate Premium (Annualized) of Euro as of Today if IRP Holds

U.S. Interest (Annualized) Quoted Today

Euro Interest (Annualized) Quoted Today

Interest Rate Differential (Annualized) Based on Today’s Quotes

30 days

4.0%

5.0%

1.0%

1.0%

90 days

4.5

5.0

.5

.5

180 days

5.0

5.0

.0

.0

1 year

5.5

5.0

.5

.5

2 years

6.0

5.0

1.0

1.0

Time to Maturity

Part 2: Exchange Rate Behavior

should be equal to its spot rate (no premium or discount). For times to maturity beyond 180 days, the euro interest rate is lower than the U.S. interest rate, which means that the forward rate of the euro would exhibit a premium if IRP holds. Consider the implications for U.S. ﬁ rms that hedge future euro payments. A ﬁ rm that is hedging euro outﬂow payments for a date of less than 180 days from now will lock in a forward rate for the euro that is lower than the existing spot rate. Conversely, a ﬁ rm that is hedging euro outﬂow payments for a date beyond 180 days from now will lock in a forward rate that is above the existing spot rate.

Changes in Forward Premiums Exhibit 7.13 illustrates the relationship between interest rate differentials and the forward premium over time. In the fourth quarter of 2000, the U.S. interest rate was

Annualized Interest Rate

Exhibit 7.13 over Time

Relationship between Interest Rate Differentials and Forward Rate Premiums

7%

(i $) U.S. Interest Rate

(i C) Euro's Interest Rate

5% 3% 1%

2000

2001

2002

2003

2004

2005

2006

2007

2006

2007

2006

2007

2% i$ iC

1% 0% 1%

i$ iC

2% 2000

Forward Premium (p) of Euro

206

2001

2002

2003

2004

2005

2% 1% Forward Premium of Euro

0% 1% 2% 2000

2001

2002

2003

2004

2005

Chapter 7: International Arbitrage and Interest Rate Parity

H T T P : // http://www .bmonesbittburns.com/ economics/fxrates Forward rates of the Canadian dollar, British pound, euro, and Japanese yen for various periods.

207

higher than the interest rate on euros, and the forward rate of the euro exhibited a premium. During the next 2 years, the U.S. interest rate declined to a greater degree than the euro’s interest rate. As the U.S. interest rate declined below the euro’s interest rate in 2001, the euro’s forward rate exhibited a discount, as the forward rate was lower than the prevailing spot rate. The larger the degree to which the euro’s interest rate exceeded the U.S. interest rate, the more pronounced was the euro’s forward discount. In 2005, the U.S. interest rate increased and rose above the euro’s interest rate, which caused the euro’s forward rate to exhibit a forward premium at that time. Since the U.S. interest rate remained above the euro’s interest rate during the 2005–2007 period, the euro consistently exhibited a forward premium during that period. How Arbitrage Reduces the Need to Monitor Transaction Costs Many MNCs engage in transactions amounting to more than $100 million per year. Since the foreign exchange market is over-the-counter, there is not one consistently transparent set of exchange quotations. Consequently, managers of an MNC could incur large transaction costs if they consistently paid too much for the currencies that they needed. However, the arbitrage process limits the degree of differentials among currencies. Locational arbitrage limits the differences in a spot exchange rate quotation across locations, while covered interest arbitrage ensures that the forward rate is properly priced. Thus, an MNC’s managers should be able to avoid excessive transaction costs. ■

GOVE ER RN NA AN NC CE E

SUMMARY ■ Locational arbitrage may occur if foreign exchange quotations differ among banks. The act of locational arbitrage should force the foreign exchange quotations of banks to become realigned, and locational arbitrage will no longer be possible. ■ Triangular arbitrage is related to cross exchange rates. A cross exchange rate between two currencies is determined by the values of these two currencies with respect to a third currency. If the actual cross exchange rate of these two currencies differs from the rate that should exist, triangular arbitrage is possible. The act of triangular arbitrage should force cross exchange rates to become realigned, at which time triangular arbitrage will no longer be possible. ■ Covered interest arbitrage is based on the relationship between the forward rate premium and the interest rate differential. The size of the premium or discount exhibited by the forward rate of a currency should be about the same as the differential between the interest rates of the two countries of concern. In general terms, the forward rate of the foreign currency will contain a discount (premium) if its interest rate is higher (lower) than the U.S. interest rate.

If the forward premium deviates substantially from the interest rate differential, covered interest arbitrage is possible. In this type of arbitrage, a foreign shortterm investment in a foreign currency is covered by a forward sale of that foreign currency in the future. In this manner, the investor is not exposed to ﬂuctuation in the foreign currency’s value. ■ Interest rate parity (IRP) is a theory that states that the size of the forward premium (or discount) should be equal to the interest rate differential between the two countries of concern. When IRP exists, covered interest arbitrage is not feasible because any interest rate advantage in the foreign country will be offset by the discount on the forward rate. Thus, the act of covered interest arbitrage would generate a return that is no higher than what would be generated by a domestic investment.

208

Part 2: Exchange Rate Behavior

POINT

COUNTER-POINT

Does Arbitrage Destabilize Foreign Exchange Markets? Point Yes. Large ﬁ nancial institutions have the technology to recognize when one participant in the foreign exchange market is trying to sell a currency for a higher price than another participant. They also recognize when the forward rate does not properly reﬂect the interest rate differential. They use arbitrage to capitalize on these situations, which results in large foreign exchange transactions. In some cases, their arbitrage involves taking large positions in a currency and then reversing their positions a few minutes later. This jumping in and out of currencies can cause abrupt price adjustments of currencies and may create more volatility in the foreign exchange market. Regulations should be created that would force ﬁ nancial institutions to maintain their currency positions for at least one month. This would result in a more stable foreign exchange market.

would become fragmented, and prices could differ substantially among banks in a region, or among regions. If the discrepancies became large enough, ﬁ rms and individuals might even attempt to conduct arbitrage themselves. The arbitrage conducted by banks allows for a more integrated foreign exchange market, which ensures that foreign exchange prices quoted by any institution are in line with the market. Who Is Correct? Use the Internet to learn more about this issue. Which argument do you support? Offer your own opinion on this issue.

Counter-Point No. When ﬁ nancial institutions engage in arbitrage, they create pressure on the price of a currency that will remove any pricing discrepancy. If arbitrage did not occur, pricing discrepancies would become more pronounced. Consequently, ﬁ rms and individuals who use the foreign exchange market would have to spend more time searching for the best exchange rate when trading a currency. The market

SELF

TEST

Answers are provided in Appendix A at the back of the text. 1. Assume that the following spot exchange rates exist today: £1 $1.50 C$ $.75 £1 C$2 Assume no transaction costs. Based on these exchange rates, can triangular arbitrage be used to earn a proﬁt? Explain. 2. Assume the following information: Spot rate of £ $1.60 180-day forward rate of £ $1.56 180-day British interest rate 4% 180-day U.S. interest rate 3%

Based on this information, is covered interest arbitrage by U.S. investors feasible (assuming that U.S. investors use their own funds)? Explain. 3. Using the information in the previous question, does interest rate parity exist? Explain. 4. Explain in general terms how various forms of arbitrage can remove any discrepancies in the pricing of currencies. 5. Assume that the British pound’s one-year forward rate exhibits a discount. Assume that interest rate parity continually exists. Explain how the discount on the British pound’s one-year forward discount would change if British one-year interest rates rose by 3 percentage points while U.S. one-year interest rates rose by 2 percentage points.

Chapter 7: International Arbitrage and Interest Rate Parity

QUESTIONS

AND

A P P L I CAT I O N S

1. Locational Arbitrage. Explain the concept of locational arbitrage and the scenario necessary for it to be plausible. 2. Locational Arbitrage. Assume the following information: Beal Bank

Yardley Bank

Bid price of New Zealand dollar

$.401

$.398

Ask price of New Zealand dollar

$.404

$.400

Given this information, is locational arbitrage possible? If so, explain the steps involved in locational arbitrage, and compute the proﬁt from this arbitrage if you had $1 million to use. What market forces would occur to eliminate any further possibilities of locational arbitrage? 3. Triangular Arbitrage. Explain the concept of triangular arbitrage and the scenario necessary for it to be plausible. 4. Triangular Arbitrage. Assume the following information: Quoted Price Value of Canadian dollar in U.S. dollars

$.90

Value of New Zealand dollar in U.S. dollars

$.30

Value of Canadian dollar in New Zealand dollars

NZ$3.02

Given this information, is triangular arbitrage possible? If so, explain the steps that would reﬂect triangular arbitrage, and compute the proﬁt from this strategy if you had $1 million to use. What market forces would occur to eliminate any further possibilities of triangular arbitrage? 5. Covered Interest Arbitrage. Explain the concept of covered interest arbitrage and the scenario necessary for it to be plausible. 6. Covered Interest Arbitrage. Assume the following information: Spot rate of Canadian dollar

$.80

90-day forward rate of Canadian dollar

$.79

90-day Canadian interest rate

4%

90-day U.S. interest rate

2.5%

209

Given this information, what would be the yield (percentage return) to a U.S. investor who used covered interest arbitrage? (Assume the investor invests $1 million.) What market forces would occur to eliminate any further possibilities of covered interest arbitrage? 7. Covered Interest Arbitrage. Assume the following information: Spot rate of Mexican peso

$.100

180-day forward rate of Mexican peso

$.098

180-day Mexican interest rate

6%

180-day U.S. interest rate

5%

Given this information, is covered interest arbitrage worthwhile for Mexican investors who have pesos to invest? Explain your answer. 8. Effects of September 11. The terrorist attack on the United States on September 11, 2001, caused expectations of a weaker U.S. economy. Explain how such expectations could have affected U.S. interest rates and therefore have affected the forward rate premium (or discount) on various foreign currencies. 9. Interest Rate Parity. Explain the concept of interest rate parity. Provide the rationale for its possible existence. 10. Inﬂation Effects on the Forward Rate. Why do you think currencies of countries with high inﬂation rates tend to have forward discounts? 11. Covered Interest Arbitrage in Both Directions. Assume that the existing U.S. one-year interest rate is 10 percent and the Canadian one-year interest rate is 11 percent. Also assume that interest rate parity exists. Should the forward rate of the Canadian dollar exhibit a discount or a premium? If U.S. investors attempt covered interest arbitrage, what will be their return? If Canadian investors attempt covered interest arbitrage, what will be their return? 12. Interest Rate Parity. Why would U.S. investors consider covered interest arbitrage in France when the interest rate on euros in France is lower than the U.S. interest rate? 13. Interest Rate Parity. Consider investors who invest in either U.S. or British one-year Treasury bills. Assume zero transaction costs and no taxes.

210

Part 2: Exchange Rate Behavior a. If interest rate parity exists, then the return for

U.S. investors who use covered interest arbitrage will be the same as the return for U.S. investors who invest in U.S. Treasury bills. Is this statement true or false? If false, correct the statement. b. If interest rate parity exists, then the return for

British investors who use covered interest arbitrage will be the same as the return for British investors who invest in British Treasury bills. Is this statement true or false? If false, correct the statement. 14. Changes in Forward Premiums. Assume that the Japanese yen’s forward rate currently exhibits a premium of 6 percent and that interest rate parity exists. If U.S. interest rates decrease, how must this premium change to maintain interest rate parity? Why might we expect the premium to change? 15. Changes in Forward Premiums. Assume that the forward rate premium of the euro was higher last month than it is today. What does this imply about interest rate differentials between the United States and Europe today compared to those last month?

c. Can a German subsidiary of a U.S. ﬁ rm beneﬁt by investing funds in the United States through covered interest arbitrage?

20. Covered Interest Arbitrage. The South African rand has a one-year forward premium of 2 percent. One-year interest rates in the United States are 3 percentage points higher than in South Africa. Based on this information, is covered interest arbitrage possible for a U.S. investor if interest rate parity holds? 21. Deriving the Forward Rate. Assume that annual interest rates in the United States are 4 percent, while interest rates in France are 6 percent. a. According to IRP, what should the forward rate premium or discount of the euro be? b. If the euro’s spot rate is $1.10, what should the one-year forward rate of the euro be?

22. Covered Interest Arbitrage in Both Directions. The following information is available: • You have $500,000 to invest.

16. Interest Rate Parity. If the relationship that is speciﬁed by interest rate parity does not exist at any period but does exist on average, then covered interest arbitrage should not be considered by U.S. ﬁ rms. Do you agree or disagree with this statement? Explain.

• The current spot rate of the Moroccan dirham is

17. Covered Interest Arbitrage in Both Directions. The one-year interest rate in New Zealand is 6 percent. The one-year U.S. interest rate is 10 percent. The spot rate of the New Zealand dollar (NZ$) is $.50. The forward rate of the New Zealand dollar is $.54. Is covered interest arbitrage feasible for U.S. investors? Is it feasible for New Zealand investors? In each case, explain why covered interest arbitrage is or is not feasible.

• The 60-day interest rate in Morocco is 2 percent.

18. Limitations of Covered Interest Arbitrage. Assume that the one-year U.S. interest rate is 11 percent, while the one-year interest rate in Malaysia is 40 percent. Assume that a U.S. bank is willing to purchase the currency of that country from you one year from now at a discount of 13 percent. Would covered interest arbitrage be worth considering? Is there any reason why you should not attempt covered interest arbitrage in this situation? (Ignore tax effects.) 19. Covered Interest Arbitrage in Both Directions. Assume that the annual U.S. interest rate is currently 8 percent and Germany’s annual interest rate is currently 9 percent. The euro’s one-year forward rate currently exhibits a discount of 2 percent. a. Does interest rate parity exist? b. Can a U.S. ﬁ rm beneﬁt from investing funds in

Germany using covered interest arbitrage?

$.110. • The 60-day forward rate of the Moroccan dir-

ham is $.108. • The 60-day interest rate in the United States is

1 percent. a. What is the yield to a U.S. investor who conducts covered interest arbitrage? Did covered interest arbitrage work for the investor in this case? b. Would covered interest arbitrage be possible for a Moroccan investor in this case?

Advanced Questions 23. Economic Effects on the Forward Rate. Assume that Mexico’s economy has expanded signiﬁcantly, causing a high demand for loanable funds there by local ﬁ rms. How might these conditions affect the forward discount of the Mexican peso? 24. Differences among Forward Rates. Assume that the 30-day forward premium of the euro is 1 percent, while the 90-day forward premium of the euro is 2 percent. Explain the likely interest rate conditions that would cause these premiums. Does this ensure that covered interest arbitrage is worthwhile? 25. Testing Interest Rate Parity. Describe a method for testing whether interest rate parity exists. Why are transaction costs, currency restrictions, and differential tax laws important when evaluating whether covered interest arbitrage can be beneﬁcial?

Chapter 7: International Arbitrage and Interest Rate Parity

26. Deriving the Forward Rate. Before the Asian crisis began, Asian central banks were maintaining a somewhat stable value for their respective currencies. Nevertheless, the forward rate of Southeast Asian currencies exhibited a discount. Explain. 27. Interpreting Changes in the Forward Premium. Assume that interest rate parity holds. At the beginning of the month, the spot rate of the Canadian dollar is $.70, while the one-year forward rate is $.68. Assume that U.S. interest rates increase steadily over the month. At the end of the month, the one-year forward rate is higher than it was at the beginning of the month. Yet, the one-year forward discount is larger (the one-year premium is more negative) at the end of the month than it was at the beginning of the month. Explain how the relationship between the U.S. interest rate and the Canadian interest rate changed from the beginning of the month until the end of the month. 28. Interpreting a Large Forward Discount. The interest rate in Indonesia is commonly higher than the interest rate in the United States, which reﬂects a high expected rate of inﬂation there. Why should Nike consider hedging its future remittances from Indonesia to the U.S. parent even when the forward discount on the currency (rupiah) is so large? 29. Change in the Forward Premium. At the end of this month, you (owner of a U.S. ﬁ rm) are meeting with a Japanese ﬁ rm to which you will try to sell supplies. If you receive an order from that ﬁ rm, you will obtain a forward contract to hedge the future receivables in yen. As of this morning, the forward rate of the yen and spot rate are the same. You believe that interest rate parity holds. This afternoon, news occurs that makes you believe that the U.S. interest rates will increase substantially by the end of this month, and that the Japanese interest rate will not change. However, your expectations of the spot rate of the Japanese yen are not affected at all in the future. How will your expected dollar amount of receivables from the Japanese transaction be affected (if at all) by the news that occurred this afternoon? Explain.

BLADES,

INC.

211

30. Testing IRP. The one-year interest rate in Singapore is 11 percent. The one-year interest rate in the United States is 6 percent. The spot rate of the Singapore dollar (S$) is $.50 and the forward rate of the S$ is $.46. Assume zero transaction costs. a. Does interest rate parity exist? b. Can a U.S. ﬁ rm beneﬁt from investing funds in

Singapore using covered interest arbitrage? 31. Implications of IRP. Assume that interest rate parity exists. You expect that the one-year nominal interest rate in the United States is 7 percent, while the one-year nominal interest rate in Australia is 11 percent. The spot rate of the Australian dollar is $.60. You will need 10 million Australian dollars in one year. Today, you purchase a one-year forward contract in Australian dollars. How many U.S. dollars will you need in one year to fulﬁ ll your forward contract? 32. Triangular Arbitrage. You go to a bank and are given these quotes: You can buy a euro for 14 pesos. The bank will pay you 13 pesos for a euro. You can buy a U.S. dollar for .9 euros. The bank will pay you .8 euros for a U.S. dollar. You can buy a U.S. dollar for 10 pesos. The bank will pay you 9 pesos for a U.S. dollar. You have $1,000. Can you use triangular arbitrage to generate a proﬁt? If so, explain the order of the transactions that you would execute and the proﬁt that you would earn. If you cannot earn a proﬁt from triangular arbitrage, explain why. Discussion in the Boardroom This exercise can be found in Appendix E at the back of this textbook. Running Your Own MNC This exercise can be found on the Xtra! website at http://maduraxtra.swlearning.com.

CASE

Assessment of Potential Arbitrage Opportunities Recall that Blades, a U.S. manufacturer of roller blades, has chosen Thailand as its primary export target for “Speedos,” Blades’ primary product. Moreover, Blades’ primary customer in Thailand, Entertainment Products, has committed itself to purchase 180,000 Speedos

annually for the next 3 years at a ﬁ xed price denominated in baht, Thailand’s currency. Because of quality and cost considerations, Blades also imports some of the rubber and plastic components needed to manufacture Speedos.

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Lately, Thailand has experienced weak economic growth and political uncertainty. As investors lost conﬁdence in the Thai baht as a result of the political uncertainty, they withdrew their funds from the country. This resulted in an excess supply of baht for sale over the demand for baht in the foreign exchange market, which put downward pressure on the baht’s value. As foreign investors continued to withdraw their funds from Thailand, the baht’s value continued to deteriorate. Since Blades has net cash ﬂows in baht resulting from its exports to Thailand, a deterioration in the baht’s value will affect the company negatively. Ben Holt, Blades’ CFO, would like to ensure that the spot and forward rates Blades’ bank has quoted are reasonable. If the exchange rate quotes are reasonable, then arbitrage will not be possible. If the quotations are not appropriate, however, arbitrage may be possible. Under these conditions, Holt would like Blades to use some form of arbitrage to take advantage of possible mispricing in the foreign exchange market. Although Blades is not an arbitrageur, Holt believes that arbitrage opportunities could offset the negative impact resulting from the baht’s depreciation, which would otherwise seriously affect Blades’ proﬁt margins. Ben Holt has identiﬁed three arbitrage opportunities as proﬁtable and would like to know which one of them is the most proﬁtable. Thus, he has asked you, Blades’ ﬁ nancial analyst, to prepare an analysis of the arbitrage opportunities he has identiﬁed. This would allow Holt to assess the proﬁtability of arbitrage opportunities very quickly. 1. The ﬁ rst arbitrage opportunity relates to locational arbitrage. Holt has obtained spot rate quotations from two banks in Thailand: Minzu Bank and Sobat Bank, both located in Bangkok. The bid and ask prices of Thai baht for each bank are displayed in the table below: Minzu Bank

Sobat Bank

Bid

$.0224

$.0228

Ask

$.0227

$.0229

Determine whether the foreign exchange quotations are appropriate. If they are not appropriate, determine the proﬁt you could generate by withdrawing $100,000 from Blades’ checking account and engaging in arbitrage before the rates are adjusted. 2. Besides the bid and ask quotes for the Thai baht provided in the previous question, Minzu Bank has

provided the following quotations for the U.S. dollar and the Japanese yen: Quoted Bid Price

Quoted Ask Price

Value of a Japanese yen in U.S. dollars

$.0085

$.0086

Value of a Thai baht in Japanese yen

¥2.69

¥2.70

Determine whether the cross exchange rate between the Thai baht and Japanese yen is appropriate. If it is not appropriate, determine the proﬁt you could generate for Blades by withdrawing $100,000 from Blades’ checking account and engaging in triangular arbitrage before the rates are adjusted. 3. Ben Holt has obtained several forward contract quotations for the Thai baht to determine whether covered interest arbitrage may be possible. He was quoted a forward rate of $.0225 per Thai baht for a 90-day forward contract. The current spot rate is $.0227. Ninety-day interest rates available to Blades in the United States are 2 percent, while 90-day interest rates in Thailand are 3.75 percent (these rates are not annualized). Holt is aware that covered interest arbitrage, unlike locational and triangular arbitrage, requires an investment of funds. Thus, he would like to be able to estimate the dollar proﬁt resulting from arbitrage over and above the dollar amount available on a 90-day U.S. deposit. Determine whether the forward rate is priced appropriately. If it is not priced appropriately, determine the proﬁt you could generate for Blades by withdrawing $100,000 from Blades’ checking account and engaging in covered interest arbitrage. Measure the proﬁt as the excess amount above what you could generate by investing in the U.S. money market. 4. Why are arbitrage opportunities likely to disappear soon after they have been discovered? To illustrate your answer, assume that covered interest arbitrage involving the immediate purchase and forward sale of baht is possible. Discuss how the baht’s spot and forward rates would adjust until covered interest arbitrage is no longer possible. What is the resulting equilibrium state called?

Chapter 7: International Arbitrage and Interest Rate Parity

SMALL

BUSINESS

213

DILEMMA

Assessment of Prevailing Spot and Forward Rates by the Sports Exports Company As the Sports Exports Company exports footballs to the United Kingdom, it receives British pounds. The check (denominated in pounds) for last month’s exports just arrived. Jim Logan (owner of the Sports Exports Company) normally deposits the check with his local bank and requests that the bank convert the check to dollars at the prevailing spot rate (assuming that he did not use a forward contract to hedge this payment). Jim’s local bank provides foreign exchange services for many of its business customers who need to buy or sell widely traded currencies. Today, however, Jim decided to check the quotations of the spot rate at other banks before converting the payment into dollars. 1. Do you think Jim will be able to ﬁ nd a bank that provides him with a more favorable spot rate than his local bank? Explain.

I N T E R N E T/ E XC E L The Bloomberg website provides quotations in foreign exchange markets. Its address is http://www.bloomberg .com. Use this web page to determine the cross exchange rate between the Canadian dollar and the Japanese yen.

2. Do you think that Jim’s bank is likely to provide more reasonable quotations for the spot rate of the British pound if it is the only bank in town that provides foreign exchange services? Explain. 3. Jim is considering using a forward contract to hedge the anticipated receivables in pounds next month. His local bank quoted him a spot rate of $1.65 and a one-month forward rate of $1.6435. Before Jim decides to sell pounds one month forward, he wants to be sure that the forward rate is reasonable, given the prevailing spot rate. A onemonth Treasury security in the United States currently offers a yield (not annualized) of 1 percent, while a one-month Treasury security in the United Kingdom offers a yield of 1.4 percent. Do you believe that the one-month forward rate is reasonable given the spot rate of $1.65?

EXERCISE Notice that the value of the pound (in dollars) and the value of the yen (in dollars) are also disclosed. Based on these values, is the cross rate between the Canadian dollar and the yen what you expected it to be? Explain.

8: Relationships among Inflation, Interest Rates, and Exchange Rates Inﬂation rates and interest rates can have a signiﬁcant impact on exchange rates (as explained in Chapter 4) and therefore can inﬂuence the value of MNCs. Financial managers of MNCs must understand how inﬂation and interest rates can affect exchange rates so that they can anticipate how their MNCs may be affected. Given their potential inﬂuence on MNC values, inﬂation and interest rates deserve to be studied more closely.

The speciﬁc objectives of this chapter are to: ■ explain the purchasing power parity (PPP) theory and

its implications for exchange rate changes, ■ explain the international Fisher effect (IFE) theory and

its implications for exchange rate changes, and ■ compare the PPP theory, the IFE theory, and the the-

ory of interest rate parity (IRP), which was introduced in the previous chapter.

Purchasing Power Parity (PPP) In Chapter 4, the expected impact of relative inﬂation rates on exchange rates was discussed. Recall from this discussion that when a country’s inﬂ ation rate rises, the demand for its currency declines as its exports decline (due to its higher prices). In addition, consumers and ﬁrms in that country tend to increase their importing. Both of these forces place downward pressure on the high-inﬂation country’s currency. Inﬂation rates often vary among countries, causing international trade patterns and exchange rates to adjust accordingly. One of the most popular and controversial theories in international ﬁnance is the purchasing power parity (PPP) theory, which attempts to quantify the inﬂation–exchange rate relationship.

Interpretations of Purchasing Power Parity There are two popular forms of PPP theory, each of which has its own implications.

Absolute Form of PPP. The absolute form of PPP is based on the notion that without international barriers, consumers shift their demand to wherever prices are lower. It suggests that prices of the same basket of products in two different countries should be equal when measured in a common currency. If a discrepancy in prices as measured by a common currency exists, the demand should shift so that these prices converge. If the same basket of products is produced by the United States and the United Kingdom, and the price in the United Kingdom is lower when measured in a common currency, the demand for that basket should increase in the United Kingdom and decline in the United States. Consequently, the actual price charged in each country may be affected, and/ or the exchange rate may adjust. Both forces would cause the prices of the baskets to be similar when measured in a common currency. ■

E X A M P L E

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215

Realistically, the existence of transportation costs, tariffs, and quotas may prevent the absolute form of PPP. If transportation costs were high in the preceding example, the demand for the baskets of products might not shift as suggested. Thus, the discrepancy in prices would continue.

Relative Form of PPP. The relative form of PPP accounts for the possibility of market imperfections such as transportation costs, tariffs, and quotas. This version acknowledges that because of these market imperfections, prices of the same basket of products in different countries will not necessarily be the same when measured in a common currency. It does state, however, that the rate of change in the prices of the baskets should be somewhat similar when measured in a common currency, as long as the transportation costs and trade barriers are unchanged. Assume that the United States and the United Kingdom trade extensively with each other and initially have zero inflation. Now assume that the United States experiences a 9 percent inflation rate, while the United Kingdom experiences a 5 percent inflation rate. Under these conditions, PPP theory suggests that the British pound should appreciate by approximately 4 percent, the differential in inflation rates. Thus, the exchange rate should adjust to offset the differential in the inflation rates of the two countries. If this occurs, the prices of goods in the two countries should appear similar to consumers. That is, the relative purchasing power when buying products in one country is similar to when buying products in the other country. ■

E X A M P L E

Rationale behind Purchasing Power Parity Theory If two countries produce products that are substitutes for each other, the demand for the products should adjust as inﬂ ation rates differ. In our previous example, the relatively high U.S. inﬂation should cause U.S. consumers to increase imports from the United Kingdom and British consumers to lower their demand for U.S. goods (since prices of British goods have increased by a lower rate). Such forces place upward pressure on the British pound’s value. The shifting in consumption from the United States to the United Kingdom will continue until the British pound’s value has appreciated to the extent that (1) the prices paid for British goods by U.S. consumers are no lower than the prices for comparable products made in the United States and (2) the prices paid for U.S. goods by British consumers are no higher than the prices for comparable products made in the United Kingdom. To achieve this new equilibrium situation, the pound will need to appreciate by approximately 4 percent, as will be veriﬁed here. Given British inﬂation of 5 percent and the pound’s appreciation of 4 percent, U.S. consumers will be paying about 9 percent more for the British goods than they paid in the initial equilibrium state. This is equal to the 9 percent increase in prices of U.S. goods from the U.S. inﬂation. Consider a situation in which the pound appreciated by only 1 percent in response to the inﬂation differential. In this case, the increased price of British goods to U.S. consumers will be approximately 6 percent (5 percent inﬂ ation and 1 percent appreciation in the British pound), which is less than the 9 percent increase in the price of U.S. goods to U.S. consumers. Thus, we would expect U.S. consumers to continue to shift their consumption to British goods. Purchasing power parity suggests that the increasing U.S. consumption of British goods by U.S. consumers would persist until the pound appreciated by about 4 percent. Any level of appreciation lower than this would represent more attractive British prices relative to U.S. prices from the U.S. consumer’s viewpoint. From the British consumer’s point of view, the price of U.S. goods would have initially increased by 4 percent more than British goods. Thus, British consumers would continue to reduce imports from the United States until the pound appreciated

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enough to make U.S. goods no more expensive than British goods. Once the pound appreciated by 4 percent, this would partially offset the increase in U.S. prices of 9 percent from the British consumer’s perspective. To be more precise, the net effect is that the prices of U.S. goods would increase by approximately 5 percent to British consumers (9 percent inﬂation minus the 4 percent savings to British consumers due to the pound’s 4 percent appreciation).

Derivation of Purchasing Power Parity Assume that the price indexes of the home country (h) and a foreign country (f ) are equal. Now assume that over time, the home country experiences an inﬂation rate of Ih, while the foreign country experiences an inﬂation rate of If . Due to inﬂation, the price index of goods in the consumer’s home country (Ph) becomes Ph (1 Ih) The price index of the foreign country (Pf) will also change due to inﬂation in that country: Pf (1 If) If Ih If , and the exchange rate between the currencies of the two countries does not change, then the consumer’s purchasing power is greater on foreign goods than on home goods. In this case, PPP does not exist. If Ih If , and the exchange rate between the currencies of the two countries does not change, then the consumer’s purchasing power is greater on home goods than on foreign goods. In this case also, PPP does not exist. The PPP theory suggests that the exchange rate will not remain constant but will adjust to maintain the parity in purchasing power. If inﬂ ation occurs and the exchange rate of the foreign currency changes, the foreign price index from the home consumer’s perspective becomes Pf 1 1 1 If 2 1 1 1 ef 2 where ef represents the percentage change in the value of the foreign currency. According to PPP theory, the percentage change in the foreign currency (ef) should change to maintain parity in the new price indexes of the two countries. We can solve for ef under conditions of PPP by setting the formula for the new price index of the foreign country equal to the formula for the new price index of the home country, as follows: Pf 1 1 1 If 2 1 1 1 ef 2 5 Ph 1 1 1 Ih 2 Solving for ef , we obtain

Ph 1 1 Pf 1 1 Ph 1 1 ef 5 Pf 1 1

1 1 ef 5

1 Ih 2 1 If 2 1 Ih 2 21 1 If 2

Since Ph equals Pf (because price indexes were initially assumed equal in both countries), they cancel, leaving ef 5

1 1 Ih 21 1 1 If

This formula reﬂects the relationship between relative inﬂation rates and the exchange rate according to PPP. Notice that if Ih If , ef should be positive. This implies that the foreign currency will appreciate when the home country’s inﬂation

Chapter 8: Relationships among Inflation, Interest Rates, and Exchange Rates

217

exceeds the foreign country’s inﬂation. Conversely, if Ih If , then ef should be negative. This implies that the foreign currency will depreciate when the foreign country’s inﬂation exceeds the home country’s inﬂation.

Using PPP to Estimate Exchange Rate Effects The relative form of PPP can be used to estimate how an exchange rate will change in response to differential inﬂation rates between countries. Assume that the exchange rate is in equilibrium initially. Then the home currency experiences a 5 percent inflation rate, while the foreign country experiences a 3 percent inflation rate. According to PPP, the foreign currency will adjust as follows:

E X X A M P L E

1 1 Ih 21 1 1 If 1 1 .05 5 21 1 1 .03

ef 5

5 .0194, or 1.94%

■

Thus, according to this example, the foreign currency should appreciate by 1.94 percent in response to the higher inﬂation of the home country relative to the foreign country. If this exchange rate change does occur, the price index of the foreign country will be as high as the index in the home country from the perspective of home country consumers. Even though inﬂation is lower in the foreign country, appreciation of the foreign currency pushes the foreign country’s price index up from the perspective of consumers in the home country. When considering the exchange rate effect, price indexes of both countries rise by 5 percent from the home country perspective. Thus, consumers’ purchasing power is the same for foreign goods and home goods. This example examines the situation when foreign inflation exceeds home inflation. Assume that the exchange rate is in equilibrium initially. Then the home country experiences a 4 percent inflation rate, while the foreign country experiences a 7 percent inflation rate. According to PPP, the foreign currency will adjust as follows:

E X A M P L E

1 1 Ih 21 1 1 If 1 1 .04 21 5 1 1 .07 5 2.028, or 22.8%

ef 5

■

Thus, according to this example, the foreign currency should depreciate by 2.8 percent in response to the higher inﬂation of the foreign country relative to the home country. Even though the inﬂation is lower in the home country, the depreciation of the foreign currency places downward pressure on the foreign country’s prices from the perspective of consumers in the home country. When considering the exchange rate impact, prices of both countries rise by 4 percent. Thus, PPP still exists due to the adjustment in the exchange rate.

Using a Simpliﬁed PPP Relationship. A simpliﬁed but less precise relationship based on PPP is ef > Ih 2 If That is, the percentage change in the exchange rate should be approximately equal to the differential in inﬂation rates between the two countries. This simpliﬁed formula

218

Part 2: Exchange Rate Behavior

is appropriate only when the inﬂation differential is small or when the value of If is close to zero.

Graphic Analysis of Purchasing Power Parity Using PPP theory, we should be able to assess the potential impact of inﬂation on exchange rates. Exhibit 8.1 is a graphic representation of PPP theory. The points on the exhibit suggest that given an inﬂ ation differential between the home and the foreign country of X percent, the foreign currency should adjust by X percent due to that inﬂation differential.

PPP Line. The diagonal line connecting all these points together is known as the purchasing power parity (PPP) line. Point A represents our earlier example in which the U.S. (considered the home country) and British inﬂation rates were assumed to be 9 and 5 percent, respectively, so that Ih If 4%. Recall that this led to the anticipated appreciation in the British pound of 4 percent, as illustrated by point A. Point B reﬂects a situation in which the inﬂation rate in the United Kingdom exceeds the inﬂation rate in the United States by 5 percent, so that Ih If 5%. This leads to anticipated depreciation of the British pound by 5 percent, as illustrated by point B. If the exchange rate does respond to inﬂation differentials as PPP theory suggests, the actual points should lie on or close to the PPP line.

Purchasing Power Disparity. Exhibit 8.2 identiﬁes areas of purchasing power disparity. Assume an initial equilibrium situation, then a change in the inﬂation rates of the two countries. If the exchange rate does not move as PPP theory suggests, there is a disparity in the purchasing power of the two countries. Point C in Exhibit 8.2 represents a situation where home inﬂation (Ih) exceeds foreign inﬂation (If) by 4 percent. Yet, the foreign currency appreciated by only 1 percent Exhibit 8.1 Illustration of Purchasing Power Parity

Ih – If (%) PPP Line A

4

2

–4

–2

2 –2

–4 B

4

% in the Foreign Currency’s Spot Rate

Chapter 8: Relationships among Inflation, Interest Rates, and Exchange Rates

219

in response to this inﬂation differential. Consequently, purchasing power disparity exists. Home country consumers’ purchasing power for foreign goods has become more favorable relative to their purchasing power for the home country’s goods. The PPP theory suggests that such a disparity in purchasing power should exist only in the short run. Over time, as the home country consumers take advantage of the disparity by purchasing more foreign goods, upward pressure on the foreign currency’s value will cause point C to move toward the PPP line. All points to the left of (or above) the PPP line represent more favorable purchasing power for foreign goods than for home goods. Point D in Exhibit 8.2 represents a situation where home inﬂ ation is 3 percent below foreign inﬂation. Yet, the foreign currency has depreciated by only 2 percent. Again, purchasing power disparity exists. The purchasing power for foreign goods has become less favorable relative to the purchasing power for the home country’s goods. The PPP theory suggests that the foreign currency in this example should have depreciated by 3 percent to fully offset the 3 percent inﬂation differential. Since the foreign currency did not weaken to this extent, the home country consumers may cease purchasing foreign goods, causing the foreign currency to weaken to the extent anticipated by PPP theory. If so, point D would move toward the PPP line. All points to the right of (or below) the PPP line represent more favorable purchasing power for home country goods than for foreign goods.

Testing the Purchasing Power Parity Theory The PPP theory not only provides an explanation of how relative inﬂ ation rates between two countries can inﬂuence an exchange rate, but it also provides information that can be used to forecast exchange rates.

Conceptual Tests of PPP. One way to test the PPP theory is to choose two countries (say, the United States and a foreign country) and compare the Exhibit 8.2 Identifying Disparity in Purchasing Power

Ih – If (%) PPP Line C

Increased Purchasing Power of Foreign Goods

3

1

–3

–1

1

3

–1

D

–3

Decreased Purchasing Power of Foreign Goods

% in the Foreign Currency’s Spot Rate

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Part 2: Exchange Rate Behavior

differential in their inﬂation rates to the percentage change in the foreign currency’s value during several time periods. Using a graph similar to Exhibit 8.2, we could plot each point representing the inﬂation differential and exchange rate percentage change for each speciﬁc time period and then determine whether these points closely resemble the PPP line as drawn in Exhibit 8.2. If the points deviate signiﬁcantly from the PPP line, then the percentage change in the foreign currency is not being inﬂuenced by the inﬂation differential in the manner PPP theory suggests. As an alternative test, several foreign countries could be compared with the home country over a given time period. Each foreign country will exhibit an inﬂation differential relative to the home country, which can be compared to the exchange rate change during the period of concern. Thus, a point can be plotted on a graph such as Exhibit 8.2 for each foreign country analyzed. If the points deviate signiﬁcantly from the PPP line, then the exchange rates are not responding to the inﬂ ation differentials in accordance with PPP theory. The PPP theory can be tested for any countries on which inﬂation information is available.

Statistical Test of PPP. A somewhat simpliﬁed statistical test of PPP can be developed by applying regression analysis to historical exchange rates and inﬂation differentials (see Appendix C for more information on regression analysis). To illustrate, let’s focus on one particular exchange rate. The quarterly percentage changes in the foreign currency value (ef) can be regressed against the inﬂation differential that existed at the beginning of each quarter, as shown here: ef 5 a0 1 a1 a

1 1 IU.S. 2 1b 1 m 1 1 If

where a 0 is a constant, a1 is the slope coefﬁcient, and m is an error term. Regression analysis would be applied to quarterly data to determine the regression coefﬁcients. The hypothesized values of a 0 and a1 are 0 and 1.0, respectively. These coefﬁcients imply that for a given inﬂation differential, there is an equal offsetting percentage change in the exchange rate, on average. The appropriate t-test for each regression coefﬁcient requires a comparison to the hypothesized value and division by the standard error (s.e.) of the coefﬁcient as follows: Test for a 0 0: a0 2 0 t5 s.e. of a0

Test for a1 1: a1 2 1 t5 s.e. of a1

Then the t-table is used to ﬁnd the critical t-value. If either t-test ﬁnds that the coefﬁcients differ signiﬁcantly from what is expected, the relationship between the inﬂation differential and the exchange rate differs from that stated by PPP theory. It should be mentioned that the appropriate lag time between the inﬂation differential and the exchange rate is subject to controversy.

Results of Tests of PPP. Much research has been conducted to test whether PPP exists. Studies by Mishkin, Adler and Dumas, and Abuaf and Jorion1 found evidence of signiﬁcant deviations from PPP that persisted for lengthy periods. A related study by Adler and Lehman 2 provided evidence against PPP even over the long term. 1 Frederic S. Mishkin, “Are Real Interest Rates Equal Across Countries? An Empirical Investigation of International Parity Conditions,” Journal of Finance (December 1984): 1345–1357; Michael Adler and Bernard Dumas, “International Portfolio Choice and Corporate Finance: A Synthesis,” Journal of Finance (June 1983): 925–984; Niso Abuaf and Philippe Jorion, “Purchasing Power in the Long Run,” Journal of Finance (March 1990): 157–174. 2 Michael Adler and Bruce Lehman, “Deviations from Purchasing Power Parity in the Long Run,” Journal of Finance (December 1983): 1471–1487.

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221

Hakkio,3 however, found that when an exchange rate deviated far from the value that would be expected according to PPP, it moved toward that value. Although the relationship between inﬂation differentials and exchange rates is not perfect even in the long run, it supports the use of inﬂation differentials to forecast long-run movements in exchange rates.

Tests of PPP for Each Currency. To further examine whether PPP H T T P : // http://www.singstat.gov.sg Comparison of the actual values of foreign currencies with the value that should exist under conditions of purchasing power parity.

is valid, Exhibit 8.3 illustrates the relationship between relative inﬂation rates and exchange rate movements over time. The inﬂation differential shown in each of the four graphs (each graph represents one foreign currency) is measured as the U.S. inﬂation rate minus the foreign inﬂation rate. The annual differential in inﬂ ation between the United States and each foreign country is represented on the vertical axis. The annual percentage change in the exchange rate of each foreign currency (relative to the U.S. dollar) is represented on the horizontal axis. The annual inﬂation differentials and percentage changes in exchange rates from 1982 to 2007 are plotted. If

Exhibit 8.3 Comparison of Annual Inﬂation Differentials and Exchange Rate Movements for Four Major Countries

U.S. Inﬂation Minus Canadian Inﬂation (%)

–30

–20

30

30

20

20

10

10

–10

10

20

% in 30 Canadian $

–30

–20

–10

10

–10

–10

–20

–20

–30

–30

U.S. Inﬂation Minus Japanese Inﬂation (%)

–30 –20

U.S. Inﬂation Minus Swiss Inﬂation (%)

30

20

20

10

10

10 –10

20

% in 30 Japanese Yen

% in 30 Swiss Franc

U.S. Inﬂation Minus British Inﬂation (%)

30

–10

20

–30

–20

–10

10 –10

–20

–20

–30

–30

20

% in 30 British Pound

3 Craig S. Hakkio, “Interest Rates and Exchange Rates—What Is the Relationship?” Economic Review, Federal Reserve Bank of Kansas City (November 1986): 33–43.

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PPP existed during the period examined, the points plotted on the graph should be near an imaginary 45-degree line, which would split the axes (like the PPP line shown in Exhibit 8.2). Although each graph shows different results, some general comments apply to all four graphs. The percentage changes in exchange rates are typically much more volatile than the inﬂation differentials. Thus, the exchange rates are changing to a greater degree than PPP theory would predict. In some years, even the direction of a currency could not have been anticipated by PPP theory. The results in Exhibit 8.3 suggest that the relationship between inﬂation differentials and exchange rate movements often becomes distorted.

H T T P : // http://ﬁnance.yahoo.com/ Click on any country listed, then click on Country Fact Sheet. The inﬂation rate in the recent year is reported, along with the average annual inﬂation rate over the last 5 years.

Limitation of PPP Tests. A limitation in testing PPP theory is that the results will vary with the base period used. For example, if 1978 is used as a base period, most subsequent periods will show a relatively overvalued dollar; by contrast, if 1984 is used, the dollar may appear undervalued in subsequent periods. The base period chosen should reﬂect an equilibrium position, since subsequent periods are evaluated in comparison to it. Unfortunately, it is difﬁcult to choose such a base period. In fact, one of the main reasons for abolishing ﬁxed exchange rates was the difﬁculty in identifying an appropriate equilibrium exchange rate.

Why Purchasing Power Parity Does Not Occur Purchasing power parity does not consistently occur because of confounding effects and because of a lack of substitutes for some traded goods. These reasons are explained next.

Confounding Effects. The PPP theory presumes that exchange rate movements are driven completely by the inﬂation differential between two countries. Yet, recall from Chapter 4 that a change in a currency’s spot rate is inﬂuenced by the following factors: e f(DINF, DINT, DINC, DGC, DEXP) where e percentage change in the spot rate DINF change in the differential between U.S. inﬂation and the foreign country’s inﬂation DINT change in the differential between the U.S. interest rate and the foreign country’s interest rate DINC change in the differential between the U.S. income level and the foreign country’s income level DGC change in government controls DEXP change in expectations of future exchange rates Since the exchange rate movement is not driven solely by DINF, the relationship between the inﬂation differential and the exchange rate movement is not as simple as suggested by PPP. Assume that Venezuela’s inflation rate is 5 percent above the U.S. inflation rate. From this information, PPP theory would suggest that the Venezuelan bolivar should depreciate by about 5 percent against the U.S. dollar. Yet, if the government of Venezuela imposes trade barriers against U.S. exports, Venezuela’s consumers and ﬁrms will not be able to adjust their spending in reaction to the inflation differential. Therefore, the exchange rate will not adjust as suggested by PPP. ■

E X A M P L E

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No Substitutes for Traded Goods. The idea behind PPP theory is that as soon as the prices become relatively higher in one country, consumers in the other country will stop buying imported goods and shift to purchasing domestic goods instead. This shift inﬂuences the exchange rate. But, if substitute goods are not available domestically, consumers may not stop buying imported goods. Reconsider the previous example in which Venezuela’s inflation is 5 percent higher than the U.S. inflation rate. If U.S. consumers do not ﬁnd suitable substitute goods at home, they may continue to buy the highly priced goods from Venezuela, and the bolivar may not depreciate as expected according to PPP theory. ■

E X A M P L E

Purchasing Power Parity in the Long Run

H T T P : // http://ﬁnance.yahoo.com/ Information about anticipated inﬂation and exchange rates for each country.

Purchasing power parity can be tested over the long run by assessing a “real” exchange rate between two currencies over time. The real exchange rate is the actual exchange rate adjusted for inﬂationary effects in the two countries of concern. In this way, the exchange rate serves as a measure of purchasing power. If a currency weakens by 10 percent but its home inﬂation is 10 percent more than inﬂation in the foreign country, the real exchange rate has not changed. The degree of weakness in the currency is offset by the lower inﬂationary effects on foreign goods. If the real exchange rate reverts to some mean level over time, this suggests that it is constant in the long run, and any deviations from the mean are temporary. Conversely, if the real exchange rate follows a random walk, this implies that it moves randomly without any predictable pattern. That is, it does not tend to revert to some mean level and therefore cannot be viewed as constant in the long run. Under these conditions, the notion of PPP is rejected because the movements in the real exchange rate appear to be more than temporary deviations from some equilibrium value. The study by Abuaf and Jorion,4 mentioned earlier, tested PPP by assessing the long-run pattern of the real exchange rate. Abuaf and Jorion state that the typical ﬁndings rejecting PPP in previous studies are questionable because of limitations in the methods used to test PPP. They suggest that deviations from PPP are substantial in the short run but are reduced by about half in 3 years. Thus, even though exchange rates deviate from the levels predicted by PPP in the short run, their deviations are reduced over the long run.

International Fisher Effect (IFE) Along with PPP theory, another major theory in international ﬁnance is the international Fisher effect (IFE) theory. It uses interest rate rather than inﬂ ation rate differentials to explain why exchange rates change over time, but it is closely related to the PPP theory because interest rates are often highly correlated with inﬂation rates. According to the so-called Fisher effect, nominal risk-free interest rates contain a real rate of return and anticipated inﬂation. If investors of all countries require the same real return, interest rate differentials between countries may be the result of differentials in expected inﬂation.

Relationship with Purchasing Power Parity Recall that PPP theory suggests that exchange rate movements are caused by inﬂation rate differentials. If real rates of interest are the same across countries, any difference in nominal interest rates could be attributed to the difference in expected inﬂation. The IFE theory suggests that foreign currencies with relatively high interest rates 4

Abuaf and Jorion, “Purchasing Power in the Long Run.”

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Part 2: Exchange Rate Behavior

will depreciate because the high nominal interest rates reﬂect expected inﬂation. The nominal interest rate would also incorporate the default risk of an investment. The following examples focus on investments that are risk free so that default risk will not have to be accounted for. The nominal interest rate is 8 percent in the United States. Investors in the United States expect a 6 percent rate of inflation, which means that they expect to earn a real return of 2 percent over one year. The nominal interest rate in Canada is 13 percent. Given that investors in Canada also require a real return of 2 percent, the expected inflation rate in Canada must be 11 percent. According to PPP theory, the Canadian dollar is expected to depreciate by approximately 5 percent against the U.S. dollar (since the Canadian inflation rate is 5 percent higher). Therefore, U.S. investors would not beneﬁt from investing in Canada because the 5 percent interest rate differential would be offset by investing in a currency that is expected to be worth 5 percent less by the end of the investment period. U.S. investors would earn 8 percent on the Canadian investment, which is the same as they could earn in the United States. ■

E X A M P L E

The IFE theory disagrees with the notion introduced in Chapter 4 that a high interest rate may entice investors from various countries to invest there and could place upward pressure on the currency. One way to reconcile the difference is to consider the possible effects on two currencies, one of which is subject to extreme interest rate and inﬂation conditions. Brazil’s prevailing nominal interest rate is frequently very high because of the high inflation there. With inflation levels sometimes exceeding 100 percent annually, people tend to spend now before prices rise. Rather than saving, they are very willing to borrow even at high interest rates to buy products now because the alternative is to defer the purchase and have to pay a much higher price later. Thus, the high nominal interest rate is attributed to the high expected inflation. Given these expectations of high inflation, even interest rates exceeding 50 percent will not entice U.S. investors because they recognize that high inflation could cause Brazil’s currency (the Brazilian real) to decline by more than 50 percent in a year, fully offsetting the high interest rate. Thus, the high interest rate in Brazil does not attract investment from U.S. investors and therefore will not cause the Brazilian real to strengthen. Instead, the high interest rate in Brazil may indicate potential depreciation of the Brazilian real, which places downward pressure on the currency’s value. This example of Brazil supports the IFE theory. Now consider a second currency, the Chilean peso. The nominal interest rate in Chile is usually only a few percentage points higher than the nominal interest rate in the United States. Chile normally has relatively low inflation, so U.S. investors are not as concerned that the Chilean peso’s value will decline due to inflationary pressure. Therefore, they may attempt to capitalize on the higher interest rate in Chile. In this case, the U.S. investment in Chile may even cause the Chilean peso’s value to increase, at least temporarily. This example of Chile does not support the IFE theory. ■

E X A M P L E

To reinforce the IFE concept, consider the outcome that would occur if the U.S. investors believed the IFE applied to Chile. The U.S. investors would assume that the slight interest advantage in Chile versus the United States reﬂected a slightly higher degree of expected inﬂ ation in Chile. The slightly higher inﬂation in Chile would be expected to cause a slight depreciation in the Chilean peso, which would offset the interest rate advantage. Thus, the return to U.S. investors from investing in Chile would be no higher than what they could earn from investing in the United States.

Implications of the IFE for Foreign Investors The implications are similar for foreign investors who attempt to capitalize on relatively high U.S. interest rates. The foreign investors will be adversely affected by the

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effects of a relatively high U.S. inﬂation rate if they try to capitalize on the high U.S. interest rates. The nominal interest rate is 8 percent in the United States and 5 percent in Japan. The expected real rate of return is 2 percent in each country. The U.S. inflation rate is expected to be 6 percent, while the inflation rate in Japan is expected to be 3 percent. According to PPP theory, the Japanese yen is expected to appreciate by the expected inflation differential of 3 percent. If the exchange rate changes as expected, Japanese investors who attempt to capitalize on the higher U.S. interest rate will earn a return similar to what they could have earned in their own country. Though the U.S. interest rate is 3 percent higher, the Japanese investors will repurchase their yen at the end of the investment period for 3 percent more than the price at which they sold yen. Therefore, their return from investing in the United States is no better than what they would have earned domestically. ■

E X X A M P L E

The IFE theory can be applied to any exchange rate, even exchange rates that involve two non-U.S. currencies. Given the information in two previous examples, the expected inflation differential between Canada and Japan is 8 percent. According to PPP theory, this inflation differential suggests that the Canadian dollar should depreciate by 8 percent against the yen. Therefore, even though Japanese investors would earn an additional 8 percent interest on a Canadian investment, the Canadian dollar would be valued at 8 percent less by the end of the period. Under these conditions, the Japanese investors would earn a return of 5 percent, which is the same as what they would earn on an investment in Japan. ■

E X X A M P L E

These possible investment opportunities, along with some others, are summarized in Exhibit 8.4. Note that wherever investors of a given country invest their funds, the expected nominal return is the same.

Derivation of the International Fisher Effect H T T P : // http://www.ny.frb.org/ research/global_economy/ index.html Exchange rate and interest rate data for various countries.

The precise relationship between the interest rate differential of two countries and the expected exchange rate change according to the IFE can be derived as follows. First, the actual return to investors who invest in money market securities (such as shortterm bank deposits) in their home country is simply the interest rate offered on those securities. The actual return to investors who invest in a foreign money market security, however, depends on not only the foreign interest rate (if) but also the percentage change in the value of the foreign currency (ef) denominating the security. The formula for the actual or “effective” (exchange-rate-adjusted) return on a foreign bank deposit (or any money market security) is r 5 1 1 1 if 2 1 1 1 ef 2 2 1 According to the IFE, the effective return on a foreign investment should, on average, be equal to the interest rate on a local money market investment: E 1 r 2 5 ih where r is the effective return on the foreign deposit and ih is the interest rate on the home deposit. We can determine the degree by which the foreign currency must change in order to make investments in both countries generate similar returns. Take the previous formula for what determines r and set it equal to ih as follows: r 5 ih 1 1 1 if 2 1 1 1 ef 2 2 1 5 ih

Exhibit 8.4 Illustration of the International Fisher Effect (IFE) from Various Investor Perspectives

Investors Residing in

Attempt to Invest in

Japan

Japan United States Canada

United States

Canada

Japan United States Canada Japan United States Canada

Expected Inﬂation Differential (Home Inﬂation Minus Foreign Inﬂation) 3% 6% 3% 3% 11% 8% 6% 3%

3%

6% 11% 5% 11% 3% 11% 6%

8% 5%

Expected Percentage Change in Currency Needed by Investors

Nominal Interest Rate to Be Earned

— 3% 8

5% 8 13

3 — 5 8 5 —

Return to Investors after Considering Exchange Rate Adjustment

Inﬂation Anticipated in Home Country

Real Return Earned by Investors

5% 5 5

3% 3 3

2% 2 2

5 8 13

8 8 8

6 6 6

2 2 2

5 8 13

13 13 13

11 11 11

2 2 2

Chapter 8: Relationships among Inflation, Interest Rates, and Exchange Rates

Now solve for ef :

227

1 1 1 if 2 1 1 1 ef 2 5 1 1 ih 1 1 ih 1 1 ef 5 1 1 if 1 1 ih ef 5 21 1 1 if

As veriﬁed here, the IFE theory contends that when ih if , ef will be positive because the relatively low foreign interest rate reﬂects relatively low inﬂationary expectations in the foreign country. That is, the foreign currency will appreciate when the foreign interest rate is lower than the home interest rate. This appreciation will improve the foreign return to investors from the home country, making returns on foreign securities similar to returns on home securities. Conversely, when if ih, ef will be negative. That is, the foreign currency will depreciate when the foreign interest rate exceeds the home interest rate. This depreciation will reduce the return on foreign securities from the perspective of investors in the home country, making returns on foreign securities no higher than returns on home securities.

Numerical Example Based on the Derivation of IFE. Given two interest rates, the value of ef can be determined from the formula that was just derived and used to forecast the exchange rate. Assume that the interest rate on a one-year insured home country bank deposit is 11 percent, and the interest rate on a one-year insured foreign bank deposit is 12 percent. For the actual returns of these two investments to be similar from the perspective of investors in the home country, the foreign currency would have to change over the investment horizon by the following percentage:

E X X A M P L E

ef 5 5

1 1 ih 21 1 1 if 1 1 .11 21 1 1 .12

5 2.0089, or 2.89% The implications are that the foreign currency denominating the foreign deposit would need to depreciate by .89 percent to make the actual return on the foreign deposit equal to 11 percent from the perspective of investors in the home country. This would make the return on the foreign investment equal to the return on a domestic investment. ■

Simpliﬁed Relationship. A more simpliﬁed but less precise relationship speciﬁed by the IFE is ef > ih 2 if That is, the percentage change in the exchange rate over the investment horizon will equal the interest rate differential between two countries. This approximation provides reasonable estimates only when the interest rate differential is small.

Graphic Analysis of the International Fisher Effect Exhibit 8.5 displays the set of points that conform to the argument behind IFE theory. For example, point E reﬂects a situation where the foreign interest rate exceeds the home interest rate by three percentage points. Yet, the foreign currency has

228

Part 2: Exchange Rate Behavior Exhibit 8.5 Illustration of IFE Line (When Exchange Rate Changes Perfectly Offset Interest Rate Differentials)

ih – if (%) IFE Line

5

3 J

F 1

–3

–5

–1

1

3

5

% in the Foreign Currency’s Spot Rate

–1

H

E

–3

G

–5

depreciated by 3 percent to offset its interest rate advantage. Thus, an investor setting up a deposit in the foreign country achieves a return similar to what is possible domestically. Point F represents a home interest rate 2 percent above the foreign interest rate. If investors from the home country establish a foreign deposit, they are at a disadvantage regarding the foreign interest rate. However, IFE theory suggests that the currency should appreciate by 2 percent to offset the interest rate disadvantage. Point F in Exhibit 8.5 also illustrates the IFE from a foreign investor’s perspective. The home interest rate will appear attractive to the foreign investor. However, IFE theory suggests that the foreign currency will appreciate by 2 percent, which, from the foreign investor’s perspective, implies that the home country’s currency denominating the investment instruments will depreciate to offset the interest rate advantage.

Points on the IFE Line. All the points along the so-called international Fisher effect (IFE) line in Exhibit 8.5 reﬂect exchange rate adjustments to offset the differential in interest rates. This means investors will end up achieving the same yield (adjusted for exchange rate ﬂuctuations) whether they invest at home or in a foreign country. To be precise, IFE theory does not suggest that this relationship will exist continuously over each time period. The point of IFE theory is that if a corporation periodically makes foreign investments to take advantage of higher foreign interest rates, it will achieve a yield that is sometimes above and sometimes below the domestic yield. Periodic investments by a U.S. corporation in an attempt to capitalize on the higher interest rates will, on average, achieve a yield similar to that by a corporation simply making domestic deposits periodically.

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Points below the IFE Line. Points below the IFE line generally reﬂect the higher returns from investing in foreign deposits. For example, point G in Ex hibit 8.5 indicates that the foreign interest rate exceeds the home interest rate by 3 percent. In addition, the foreign currency has appreciated by 2 percent. The combination of the higher foreign interest rate plus the appreciation of the foreign currency will cause the foreign yield to be higher than what is possible domestically. If actual data were compiled and plotted, and the vast majority of points were below the IFE line, this would suggest that investors of the home country could consistently increase their investment returns by establishing foreign bank deposits. Such results would refute the IFE theory.

Points above the IFE Line. Points above the IFE line generally reﬂect returns from foreign deposits that are lower than the returns possible domestically. For example, point H reﬂects a foreign interest rate that is 3 percent above the home interest rate. Yet, point H also indicates that the exchange rate of the foreign currency has depreciated by 5 percent, more than offsetting its interest rate advantage. As another example, point J represents a situation in which an investor of the home country is hampered in two ways by investing in a foreign deposit. First, the foreign interest rate is lower than the home interest rate. Second, the foreign currency depreciates during the time the foreign deposit is held. If actual data were compiled and plotted, and the vast majority of points were above the IFE line, this would suggest that investors of the home country would receive consistently lower returns from foreign investments as opposed to investments in the home country. Such results would refute the IFE theory.

Tests of the International Fisher Effect H T T P : // http://www.economagic .com/fedstl.htm U.S. inﬂation and exchange rate data.

If the actual points (one for each period) of interest rates and exchange rate changes were plotted over time on a graph such as Exhibit 8.5, we could determine whether the points are systematically below the IFE line (suggesting higher returns from foreign investing), above the line (suggesting lower returns from foreign investing), or evenly scattered on both sides (suggesting a balance of higher returns from foreign investing in some periods and lower foreign returns in other periods). Exhibit 8.6 is an example of a set of points that tend to support the IFE theory. It implies that returns from short-term foreign investments are, on average, about equal to the returns that are possible domestically. Notice that each individual point reﬂects a change in the exchange rate that does not exactly offset the interest rate differential. In some cases, the exchange rate change does not fully offset the interest rate differential. In other cases, the exchange rate change more than offsets the interest rate differential. Overall, the results balance out such that the interest rate differentials are, on average, offset by changes in the exchange rates. Thus, foreign investments have generated yields that are, on average, equal to those of domestic investments. If foreign yields are expected to be about equal to domestic yields, a U.S. ﬁrm would probably prefer the domestic investments. The ﬁrm would know the yield on domestic short-term securities (such as bank deposits) in advance, whereas the yield to be attained from foreign short-term securities would be uncertain because the ﬁrm would not know what spot exchange rate would exist at the securities’ maturity. Investors generally prefer an investment whose return is known over an investment whose return is uncertain, assuming that all other features of the investments are similar.

Results from Testing the IFE. Whether the IFE holds in reality depends on the particular time period examined. Although the IFE theory may hold dur-

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Part 2: Exchange Rate Behavior

ing some time frames, there is evidence that it does not consistently hold. A study by Thomas5 tested the IFE theory by examining the results of (1) purchasing currency futures contracts of currencies with high interest rates that contained forward discounts (relative to the spot rates) and (2) selling futures on currencies with low interest rates that contained forward premiums. If the high-interest-rate currencies depreciated and the low-interest-rate currencies appreciated to the extent suggested by the IFE theory, this strategy would not generate signiﬁcant proﬁts. However, 57 percent of the transactions created by this strategy were proﬁtable. In addition, the average gain was much higher than the average loss. This study indicates that the IFE does not hold.

Statistical Test of the IFE. A somewhat simpliﬁed statistical test of the IFE can be developed by applying regression analysis to historical exchange rates and the nominal interest rate differential: ef 5 a0 1 a1 a

1 1 iU.S. 2 1b 1 m 1 1 if

where a 0 is a constant, a1 is the slope coefﬁcient, and m is an error term. Regression analysis would determine the regression coefﬁcients. The hypothesized values of a 0 and a1 are 0 and 1.0, respectively. The appropriate t-test for each regression coefﬁcient requires a comparison to the hypothesized value and then division by the standard error (s.e.) of the coefﬁcients, as follows: Exhibit 8.6 Illustration of IFE Concept (When Exchange Rate Changes Offset Interest Rate Differentials on Average)

ih – if (%) IFE Line

% in the Foreign Currency’s Spot Rate

5 Lee R. Thomas, “A Winning Strategy for Currency-Futures Speculation,” Journal of Portfolio Management (Fall 1985): 65–69.

Chapter 8: Relationships among Inflation, Interest Rates, and Exchange Rates

Test for a 0 0: a0 2 0 t5 s.e. of a0

231

Test for a1 1: a1 2 1 t5 s.e. of a1

The t-table is then used to ﬁnd the critical t-value. If either t-test ﬁnds that the coefﬁcients differ signiﬁcantly from what was hypothesized, the IFE is refuted.

Why the International Fisher Effect Does Not Occur As mentioned earlier in this chapter, purchasing power parity (PPP) has not held over certain periods. Since the IFE is based on purchasing power parity, it does not consistently hold either. Because exchange rates can be affected by factors other than inﬂ ation, exchange rates do not always adjust in accordance with the inﬂation differential. Assume a nominal interest rate in a foreign country that is 3 percent above the U.S. rate because expected inﬂation in that country is 3 percent above expected U.S. inﬂation. Even if these nominal rates properly reﬂect inﬂationary expectations, the exchange rate of the foreign currency will react to other factors in addition to the inﬂation differential. If these other factors put upward pressure on the foreign currency’s value, they will offset the downward pressure from the inﬂation differential. Consequently, foreign investments will achieve higher returns for the U.S. investors than domestic investments will.

Comparison of the IRP, PPP, and IFE Theories At this point, it may be helpful to compare three related theories of international ﬁnance: (1) interest rate parity (IRP), discussed in Chapter 7, (2) purchasing power parity (PPP), and (3) the international Fisher effect (IFE). Exhibit 8.7 summarizes the main themes of each theory. Note that although all three theories relate to the determination of exchange rates, they have different implications. The IRP theory focuses on why the forward rate differs from the spot rate and on the degree of difference that should exist. It relates to a speciﬁc point in time. In contrast, the PPP theory and IFE theory focus on how a currency’s spot rate will change over time. Whereas PPP theory suggests that the spot rate will change in accordance with inﬂation differentials, Exhibit 8.7 Comparison of the IRP, PPP, and IFE Theories

Interest Rate Parity (IRP)

Fisher Effect

Inﬂation Rate Differential PPP

Interest Rate Differential

Forward Rate Discount or Premium

International Fisher Effect (IFE)

Exchange Rate Expectations (continued on next page)

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Part 2: Exchange Rate Behavior

Exhibit 8.7 Comparison of the IRP, PPP, and IFE Theories (continued) Theory

Key Variables of Theory

Summary of Theory

Interest rate parity (IRP)

Forward rate premium (or discount)

Interest rate differential

The forward rate of one currency with respect to another will contain a premium (or discount) that is determined by the differential in interest rates between the two countries. As a result, covered interest arbitrage will provide a return that is no higher than a domestic return.

Purchasing power parity (PPP)

Percentage change in spot exchange rate

Inﬂation rate differential

The spot rate of one currency with respect to another will change in reaction to the differential in inﬂation rates between the two countries. Consequently, the purchasing power for consumers when purchasing goods in their own country will be similar to their purchasing power when importing goods from the foreign country.

International Fisher effect (IFE)

Percentage change in spot exchange rate

Interest rate differential

The spot rate of one currency with respect to another will change in accordance with the differential in interest rates between the two countries. Consequently, the return on uncovered foreign money market securities will, on average, be no higher than the return on domestic money market securities from the perspective of investors in the home country.

IFE theory suggests that it will change in accordance with interest rate differentials. Nevertheless, PPP is related to IFE because expected inﬂation differentials inﬂuence the nominal interest rate differentials between two countries. Some generalizations about countries can be made by applying these theories. High-inﬂation countries tend to have high nominal interest rates (due to the Fisher effect). Their currencies tend to weaken over time (because of the PPP and IFE), and the forward rates of their currencies normally exhibit large discounts (due to IRP).

SUMMARY ■ Purchasing power parity (PPP) theory speciﬁes a precise relationship between relative inﬂation rates of two countries and their exchange rate. In inexact terms, PPP theory suggests that the equilibrium exchange rate will adjust by the same magnitude as the differential in inﬂation rates between two countries. Though PPP continues to be a valuable concept, there is evidence of sizable deviations from the theory in the real world. ■ The international Fisher effect (IFE) speciﬁes a precise relationship between relative interest rates of two countries and their exchange rates. It suggests that an investor who periodically invests in foreign interest-bearing securities will, on average, achieve a return similar to what is possible domestically. This implies that the exchange rate of the country with high interest rates will depreciate to offset the inter-

est rate advantage achieved by foreign investments. However, there is evidence that during some periods the IFE does not hold. Thus, investment in foreign short-term securities may achieve a higher return than what is possible domestically. If a ﬁrm attempts to achieve this higher return, however, it does incur the risk that the currency denominating the foreign security might depreciate against the investor’s home currency during the investment period. In this case, the foreign security could generate a lower return than a domestic security, even though it exhibits a higher interest rate. ■ The PPP theory focuses on the relationship between the inﬂation rate differential and future exchange rate movements. The IFE focuses on the interest rate differential and future exchange rate movements. The theory of interest rate parity (IRP)

Chapter 8: Relationships among Inflation, Interest Rates, and Exchange Rates

focuses on the relationship between the interest rate differential and the forward rate premium (or discount) at a given point in time. ■ If IRP exists, it is not possible to beneﬁt from covered interest arbitrage. Investors can still attempt to beneﬁt from high foreign interest rates if they re-

POINT

233

main uncovered (do not sell the currency forward). But IFE suggests that this strategy will not generate higher returns than what are possible domestically because the exchange rate is expected to decline, on average, by the amount of the interest rate differential.

COUNTER-POINT

Does PPP Eliminate Concerns about Long-Term Exchange Rate Risk? Point Yes. Studies have shown that exchange rate movements are related to inﬂation differentials in the long run. Based on PPP, the currency of a highinﬂation country will depreciate against the dollar. A subsidiary in that country should generate inﬂated revenue from the inﬂation, which will help offset the adverse exchange effects when its earnings are remitted to the parent. If a ﬁrm is focused on long-term performance, the deviations from PPP will offset over time. In some years, the exchange rate effects may exceed the inﬂation effects, and in other years the inﬂation effects will exceed the exchange rate effects.

be offsetting. A subsidiary in a high-inﬂation country will not necessarily be able to adjust its price level to keep up with the increased costs of doing business there. The effects vary with each MNC’s situation. Even if the subsidiary can raise its prices to match the rising costs, there are short-term deviations from PPP. The investors who invest in an MNC’s stock may be concerned about short-term deviations from PPP because they will not necessarily hold the stock for the long term. Thus, investors may prefer that ﬁrms manage in a manner that reduces the volatility in their performance in short-run and long-run periods.

Counter-Point No. Even if the relationship between inﬂation and exchange rate effects is consistent, this does not guarantee that the effects on the ﬁrm will

Who Is Correct? Use the Internet to learn more about this issue. Which argument do you support? Offer your own opinion on this issue.

SELF

TEST

Answers are provided in Appendix A at the back of the text. 1. A U.S. importer of Japanese computer components pays for the components in yen. The importer is not concerned about a possible increase in Japanese prices (charged in yen) because of the likely offsetting effect caused by purchasing power parity (PPP). Explain what this means. 2. Use what you know about tests of PPP to answer this question. Using the information in the ﬁrst question, explain why the U.S. importer of Japanese computer components should be concerned about its future payments. 3. Use PPP to explain how the values of the currencies of Eastern European countries might change if those countries experience high inﬂation, while the United States experiences low inﬂation.

4. Assume that the Canadian dollar’s spot rate is $.85 and that the Canadian and U.S. inﬂation rates are similar. Then assume that Canada experiences 4 percent inﬂation, while the United States experiences 3 percent inﬂation. According to PPP, what will be the new value of the Canadian dollar after it adjusts to the inﬂationary changes? (You may use the approximate formula to answer this question.) 5. Assume that the Australian dollar’s spot rate is $.90 and that the Australian and U.S. one-year interest rates are initially 6 percent. Then assume that the Australian one-year interest rate increases by 5 percentage points, while the U.S. one-year interest rate remains unchanged. Using this information and the international Fisher effect (IFE) theory, forecast the spot rate for one year ahead.

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Part 2: Exchange Rate Behavior

6. In the previous question, the Australian interest rates increased from 6 to 11 percent. According to the IFE, what is the underlying factor that would cause such a change? Give an explanation based on

QUESTIONS 1. PPP. Explain the theory of purchasing power parity (PPP). Based on this theory, what is a general forecast of the values of currencies in countries with high inﬂation? 2. Rationale of PPP. Explain the rationale of the PPP theory. 3. Testing PPP. Explain how you could determine whether PPP exists. Describe a limitation in testing whether PPP holds. 4. Testing PPP. Inﬂation differentials between the United States and other industrialized countries have typically been a few percentage points in any given year. Yet, in many years annual exchange rates between the corresponding currencies have changed by 10 percent or more. What does this information suggest about PPP? 5. Limitations of PPP. Explain why PPP does not hold. 6. Implications of IFE. Explain the international Fisher effect (IFE). What is the rationale for the existence of the IFE? What are the implications of the IFE for ﬁrms with excess cash that consistently invest in foreign Treasury bills? Explain why the IFE may not hold. 7. Implications of IFE. Assume U.S. interest rates are generally above foreign interest rates. What does this suggest about the future strength or weakness of the dollar based on the IFE? Should U.S. investors invest in foreign securities if they believe in the IFE? Should foreign investors invest in U.S. securities if they believe in the IFE? 8. Comparing Parity Theories. Compare and contrast interest rate parity (discussed in the previous chapter), purchasing power parity (PPP), and the international Fisher effect (IFE). 9. Real Interest Rate. One assumption made in developing the IFE is that all investors in all countries have the same real interest rate. What does this mean? 10. Interpreting Inﬂationary Expectations. If investors in the United States and Canada require the same real interest rate, and the nominal rate of interest is 2 percent higher in Canada, what does this imply

the IFE of the forces that would cause a change in the Australian dollar. If U.S. investors believe in the IFE, will they attempt to capitalize on the higher Australian interest rates? Explain.

AND

A P P L I CAT I O N S

about expectations of U.S. inﬂation and Canadian inﬂation? What do these inﬂationary expectations suggest about future exchange rates? 11. PPP Applied to the Euro. Assume that several European countries that use the euro as their currency experience higher inﬂation than the United States, while two other European countries that use the euro as their currency experience lower inﬂation than the United States. According to PPP, how will the euro’s value against the dollar be affected? 12. Source of Weak Currencies. Currencies of some Latin American countries, such as Brazil and Venezuela, frequently weaken against most other currencies. What concept in this chapter explains this occurrence? Why don’t all U.S.-based MNCs use forward contracts to hedge their future remittances of funds from Latin American countries to the United States if they expect depreciation of the currencies against the dollar? 13. PPP. Japan has typically had lower inﬂation than the United States. How would one expect this to affect the Japanese yen’s value? Why does this expected relationship not always occur? 14. IFE. Assume that the nominal interest rate in Mexico is 48 percent and the interest rate in the United States is 8 percent for one-year securities that are free from default risk. What does the IFE suggest about the differential in expected inﬂation in these two countries? Using this information and the PPP theory, describe the expected nominal return to U.S. investors who invest in Mexico. 15. IFE. Shouldn’t the IFE discourage investors from attempting to capitalize on higher foreign interest rates? Why do some investors continue to invest overseas, even when they have no other transactions overseas? 16. Changes in Inﬂation. Assume that the inﬂation rate in Brazil is expected to increase substantially. How will this affect Brazil’s nominal interest rates and the value of its currency (called the real)? If the IFE holds, how will the nominal return to U.S. investors who invest in Brazil be affected by the higher inﬂation in Brazil? Explain.

Chapter 8: Relationships among Inflation, Interest Rates, and Exchange Rates

235

17. Comparing PPP and IFE. How is it possible for PPP to hold if the IFE does not?

importers? That is, how will U.S. importers of Russian goods be affected by the conditions?

18. Estimating Depreciation Due to PPP. Assume that the spot exchange rate of the British pound is $1.73. How will this spot rate adjust according to PPP if the United Kingdom experiences an inﬂation rate of 7 percent while the United States experiences an inﬂation rate of 2 percent?

22. IFE Application to Asian Crisis. Before the Asian crisis, many investors attempted to capitalize on the high interest rates prevailing in the Southeast Asian countries although the level of interest rates primarily reﬂected expectations of inﬂation. Explain why investors behaved in this manner. Why does the IFE suggest that the Southeast Asian countries would not have attracted foreign investment before the Asian crisis despite the high interest rates prevailing in those countries?

19. Forecasting the Future Spot Rate Based on IFE. Assume that the spot exchange rate of the Singapore dollar is $.70. The one-year interest rate is 11 percent in the United States and 7 percent in Singapore. What will the spot rate be in one year according to the IFE? What is the force that causes the spot rate to change according to the IFE? 20. Deriving Forecasts of the Future Spot Rate. As of today, assume the following information is available: U.S.

Mexico

2%

2%

11%

15%

Spot rate

—

$.20

One-year forward rate

—

$.19

Real rate of interest required by investors Nominal interest rate

a. Use the forward rate to forecast the percentage change in the Mexican peso over the next year. b. Use the differential in expected inﬂation to fore-

cast the percentage change in the Mexican peso over the next year. c. Use the spot rate to forecast the percentage

change in the Mexican peso over the next year. 21. Inﬂation and Interest Rate Effects. The opening of Russia’s market has resulted in a highly volatile Russian currency (the ruble). Russia’s inﬂation has commonly exceeded 20 percent per month. Russian interest rates commonly exceed 150 percent, but this is sometimes less than the annual inﬂation rate in Russia.

23. IFE Applied to the Euro. Given the conversion of several European currencies to the euro, explain what would cause the euro’s value to change against the dollar according to the IFE. Advanced Questions 24. IFE. Beth Miller does not believe that the international Fisher effect (IFE) holds. Current one-year interest rates in Europe are 5 percent, while oneyear interest rates in the United States are 3 percent. Beth converts $100,000 to euros and invests them in Germany. One year later, she converts the euros back to dollars. The current spot rate of the euro is $1.10. a. According to the IFE, what should the spot rate

of the euro in one year be? b. If the spot rate of the euro in one year is $1.00,

what is Beth’s percentage return from her strategy? c. If the spot rate of the euro in one year is $1.08,

what is Beth’s percentage return from her strategy? d. What must the spot rate of the euro be in one

year for Beth’s strategy to be successful? 25. Integrating IRP and IFE. Assume the following information is available for the United States and Europe: U.S.

Europe

a. Explain why the high Russian inﬂation has put

Nominal interest rate

4%

6%

severe pressure on the value of the Russian ruble.

Expected inﬂation

2%

5%

b. Does the effect of Russian inﬂation on the de-

Spot rate

—

$1.13

cline in the ruble’s value support the PPP theory? How might the relationship be distorted by political conditions in Russia?

One-year forward rate

—

$1.10

c. Does it appear that the prices of Russian goods

a. Does IRP hold?

will be equal to the prices of U.S. goods from the perspective of Russian consumers (after considering exchange rates)? Explain.

b. According to PPP, what is the expected spot rate

d. Will the effects of the high Russian inﬂation and

rate of the euro in one year?

the decline in the ruble offset each other for U.S.

d. Reconcile your answers to parts (a) and (c).

of the euro in one year? c. According to the IFE, what is the expected spot

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Part 2: Exchange Rate Behavior

26. IRP. The one-year risk-free interest rate in Mexico is 10 percent. The one-year risk-free rate in the United States is 2 percent. Assume that interest rate parity exists. The spot rate of the Mexican peso is $.14. a. What is the forward rate premium? b. What is the one-year forward rate of the peso? c. Based on the international Fisher effect, what is

the expected change in the spot rate over the next year? d. If the spot rate changes as expected according to

the IFE, what will be the spot rate in one year? e. Compare your answers to (b) and (d) and explain

the relationship. 27. Testing the PPP. How could you use regression analysis to determine whether the relationship speciﬁed by PPP exists on average? Specify the model, and describe how you would assess the regression results to determine if there is a signiﬁcant difference from the relationship suggested by PPP. 28. Testing the IFE. Describe a statistical test for the IFE. 29. Impact of Barriers on PPP and IFE. Would PPP be more likely to hold between the United States and Hungary if trade barriers were completely removed and if Hungary’s currency were allowed to ﬂoat without any government intervention? Would the IFE be more likely to hold between the United States and Hungary if trade barriers were completely removed and if Hungary’s currency were allowed to ﬂoat without any government intervention? Explain. 30. Interactive Effects of PPP. Assume that the inﬂation rates of the countries that use the euro are very low, while other European countries that have their own currencies experience high inﬂation. Explain how and why the euro’s value could be expected to change against these currencies according to the PPP theory. 31. Applying IRP and IFE. Assume that Mexico has a one-year interest rate that is higher than the U.S. one-year interest rate. Assume that you believe in the international Fisher effect (IFE) and interest rate parity. Assume zero transaction costs. Ed is based in the United States and attempts to speculate by purchasing Mexican pesos today, investing the pesos in a risk-free asset for a year, and then converting the pesos to dollars at the end of one year. Ed did not cover his position in the forward market.

Maria is based in Mexico and attempts covered interest arbitrage by purchasing dollars today and simultaneously selling dollars one year forward, investing the dollars in a risk-free asset for a year, and then converting the dollars back to pesos at the end of one year. Do you think the rate of return on Ed’s investment will be higher than, lower than, or the same as the rate of return on Maria’s investment? Explain. 32. Arbitrage and PPP. Assume that locational arbitrage ensures that spot exchange rates are properly aligned. Also assume that you believe in purchasing power parity. The spot rate of the British pound is $1.80. The spot rate of the Swiss franc is 0.3 pounds. You expect that the one-year inﬂation rate is 7 percent in the United Kingdom, 5 percent in Switzerland, and 1 percent in the United States. The one-year interest rate is 6 percent in the United Kingdom, 2 percent in Switzerland, and 4 percent in the United States. What is your expected spot rate of the Swiss franc in one year with respect to the U.S. dollar? Show your work. 33. IRP versus IFE. You believe that interest rate parity and the international Fisher effect hold. Assume that the U.S. interest rate is presently much higher than the New Zealand interest rate. You have receivables of 1 million New Zealand dollars that you will receive in one year. You could hedge the receivables with the one-year forward contract. Or, you could decide to not hedge. Is your expected U.S. dollar amount of the receivables in one year from hedging higher, lower, or the same as your expected U.S. dollar amount of the receivables without hedging? Explain. 34. IRP, PPP, and Speculating in Currency Derivatives. The U.S. 3-month interest rate (unannualized) is 1 percent. The Canadian 3-month interest rate (unannualized) is 4 percent. Interest rate parity exists. The expected inﬂation over this period is 5 percent in the United States and 2 percent in Canada. A call option with a 3-month expiration date on Canadian dollars is available for a premium of $.02 and a strike price of $.64. The spot rate of the Canadian dollar is $.65. Assume that you believe in purchasing power parity. a. Determine the dollar amount of your proﬁt or loss from buying a call option contract specifying C$100,000. b. Determine the dollar amount of your proﬁt or loss from buying a futures contract specifying C$100,000.

Chapter 8: Relationships among Inflation, Interest Rates, and Exchange Rates

35. Implications of PPP. Today’s spot rate of the Mexican peso is $.10. Assume that purchasing power parity holds. The U.S. inﬂation rate over this year is expected to be 7 percent, while the Mexican inﬂation over this year is expected to be 3 percent. Wake Forest Co. plans to import from Mexico and will need 20 million Mexican pesos in one year. Determine the expected amount of dollars to be paid by the Wake Forest Co. for the pesos in one year. 36. Investment Implications of IRP and IFE. The Argentine one-year CD (deposit) rate is 13 percent, while the Mexican one-year CD rate is 11 percent and the U.S. one-year CD rate is 6 percent. All CDs have zero default risk. Interest rate parity holds, and you believe that the international Fisher effect holds. Jamie (based in the United States) invests in a one-year CD in Argentina. Ann (based in the United States) invests in a one-year CD in Mexico. Ken (based in the United States) invests in a oneyear CD in Argentina and sells Argentine pesos one year forward to cover his position. Juan (who lives in Argentina) invests in a oneyear CD in the United States. Maria (who lives in Mexico) invests in a one-year CD in the United States. Nina (who lives in Mexico) invests in a one-year CD in Argentina. Carmen (who lives in Argentina) invests in a oneyear CD in Mexico and sells Mexican pesos one year forward to cover her position. Corio (who lives in Mexico) invests in a one-year CD in Argentina and sells Argentine pesos one year forward to cover his position. Based on this information and assuming the international Fisher effect holds, which person will be expected to earn the highest return on the funds invested? If you believe that multiple persons will tie for the highest expected return, name each of them. Explain. 37. Investment Implications of IRP and the IFE. Today, a U.S. dollar can be exchanged for 3 New Zealand dollars. The one-year CD (deposit) rate in New Zealand is 7 percent, and the one-year CD rate in the United States is 6 percent. Interest rate parity exists between the United States and New Zealand. The international Fisher effect exists between the United States and New Zealand. Today a U.S.

237

dollar can be exchanged for 2 Swiss francs. The one-year CD rate in Switzerland is 5 percent. The spot rate of the Swiss franc is the same as the oneyear forward rate. Karen (based in the United States) invests in a one-year CD in New Zealand and sells New Zealand dollars one year forward to cover her position. James (based in the United States) invests in a one-year CD in New Zealand and does not cover his position. Brian (based in the United States) invests in a one-year CD in Switzerland and sells Swiss francs one year forward to cover his position. Eric (who lives in Switzerland) invests in a oneyear CD in Switzerland. Sandra (who lives in the United States) invests in a one-year CD in Switzerland and sells Swiss francs one year forward to cover her position. Tonya (who lives in New Zealand) invests in a one-year CD in the United States and sells U.S. dollars one year forward to cover her position. Based on this information, which person will be expected to earn the highest return on the funds invested? If you believe that multiple persons will tie for the highest expected return, name each of them. Explain. 38. Real Interest Rates, Expected Inﬂation, IRP, and the Spot Rate. The United States and the country of Rueland have the same real interest rate of 3 percent. The expected inﬂation over the next year is 6 percent in the United States versus 21 percent in Rueland. Interest rate parity exists. The one-year currency futures contract on Rueland’s currency (called the ru) is priced at $.40 per ru. What is the spot rate of the ru? Discussion in the Boardroom This exercise can be found in Appendix E at the back of this textbook. Running Your Own MNC This exercise can be found on the Xtra! website at http://maduraxtra.swlearning.com.

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Part 2: Exchange Rate Behavior

BLADES,

INC.

CASE

Assessment of Purchasing Power Parity Blades, the U.S.-based roller blades manufacturer, is currently both exporting to and importing from Thailand. The company has chosen Thailand as an export target for its primary product, “Speedos,” because of Thailand’s growth prospects and the lack of competition from both Thai and U.S. roller blade manufacturers in Thailand. Under an existing arrangement, Blades sells 180,000 pairs of Speedos annually to Entertainment Products, Inc., a Thai retailer. The arrangement involves a ﬁxed, baht-denominated price and will last for 3 years. Blades generates approximately 10 percent of its revenue in Thailand. Blades has also decided to import certain rubber and plastic components needed to manufacture Speedos because of cost and quality considerations. Speciﬁcally, the weak economic conditions in Thailand resulting from recent events have allowed Blades to import components from the country at a relatively low cost. However, Blades did not enter into a long-term arrangement to import these components and pays market prices (in baht) prevailing in Thailand at the time of purchase. Currently, Blades incurs about 4 percent of its cost of goods sold in Thailand. Although Blades has no immediate plans for expansion in Thailand, it may establish a subsidiary there in the future. Moreover, even if Blades does not establish a subsidiary in Thailand, it will continue exporting to and importing from the country for several years. Due to these considerations, Blades’ management is very concerned about recent events in Thailand and neighboring countries, as they may affect both Blades’ current performance and its future plans. Ben Holt, Blades’ CFO, is particularly concerned about the level of inﬂation in Thailand. Blades’ export arrangement with Entertainment Products, while allowing for a minimum level of revenue to be generated in Thailand in a given year, prevents Blades from adjusting prices according to the level of inﬂation in Thailand. In retrospect, Holt is wondering whether Blades should have entered into the export arrangement at all. Because Thailand’s economy was growing very fast when Blades agreed to the arrangement, strong consumer spending there resulted in a high level of inﬂation and high interest rates. Naturally, Blades would have preferred an agreement whereby the price per pair of Speedos would be adjusted for the Thai level of inﬂation. However, to take advantage of the growth opportunities in Thailand, Blades accepted the arrangement when Entertainment Products insisted on a ﬁxed price level. Currently, however, the baht is freely

ﬂoating, and Holt is wondering how a relatively high level of Thai inﬂation may affect the baht-dollar exchange rate and, consequently, Blades’ revenue generated in Thailand. Ben Holt is also concerned about Blades’ cost of goods sold incurred in Thailand. Since no ﬁxed-price arrangement exists and the components are invoiced in Thai baht, Blades has been subject to increases in the prices of rubber and plastic. Holt is wondering how a potentially high level of inﬂation will impact the bahtdollar exchange rate and the cost of goods sold incurred in Thailand now that the baht is freely ﬂoating. When Holt started thinking about future economic conditions in Thailand and the resulting impact on Blades, he found that he needed your help. In particular, Holt is vaguely familiar with the concept of purchasing power parity (PPP) and is wondering about this theory’s implications, if any, for Blades. Furthermore, Holt also remembers that relatively high interest rates in Thailand will attract capital ﬂows and put upward pressure on the baht. Because of these concerns, and to gain some insight into the impact of inﬂation on Blades, Ben Holt has asked you to provide him with answers to the following questions: 1. What is the relationship between the exchange rates and relative inﬂation levels of the two countries? How will this relationship affect Blades’ Thai revenue and costs given that the baht is freely ﬂoating? What is the net effect of this relationship on Blades? 2. What are some of the factors that prevent PPP from occurring in the short run? Would you expect PPP to hold better if countries negotiate trade arrangements under which they commit themselves to the purchase or sale of a ﬁxed number of goods over a speciﬁed time period? Why or why not? 3. How do you reconcile the high level of interest rates in Thailand with the expected change of the baht-dollar exchange rate according to PPP? 4. Given Blades’ future plans in Thailand, should the company be concerned with PPP? Why or why not? 5. PPP may hold better for some countries than for others. The Thai baht has been freely ﬂoating for more than a decade. How do you think Blades can gain insight into whether PPP holds for Thailand? Offer some logic to explain why the PPP relationship may not hold here.

Chapter 8: Relationships among Inflation, Interest Rates, and Exchange Rates

SMALL

BUSINESS

239

DILEMMA

Assessment of the IFE by the Sports Exports Company Every month, the Sports Exports Company receives a payment denominated in British pounds for the footballs it exports to the United Kingdom. Jim Logan, owner of the Sports Exports Company, decides each month whether to hedge the payment with a forward contract for the following month. Now, however, he is questioning whether this process is worth the trouble. He suggests that if the international Fisher effect (IFE) holds, the pound’s value should change (on average) by an amount that reﬂects the differential between the interest rates of the two countries of concern. Since the

I N T E R N E T/ E XC E L

forward premium reﬂects that same interest rate differential, the results from hedging should equal the results from not hedging on average. 1. Is Jim’s interpretation of the IFE theory correct? 2. If you were in Jim’s position, would you spend time trying to decide whether to hedge the receivables each month, or do you believe that the results would be the same (on average) whether you hedged or not?

EXERCISES

The “Market” section of the Bloomberg website provides interest rate quotations for numerous currencies. Its address is http://www.bloomberg.com.

expected rate of inﬂation over the next year in each of these countries that is implied by the nominal interest rate (according to the Fisher effect).

1. Go to the “Rates and Bonds” section and then click on each foreign country to review its interest rate. Determine the prevailing one-year interest rate of the Australian dollar, the Japanese yen, and the British pound. Assuming a 2 percent real rate of interest for savers in any country, determine the

2. What is the approximate expected percentage change in the value of each of these currencies against the dollar over the next year when applying PPP to the inﬂation level of each of these currencies versus the dollar?

PART 2 INTEGRATIVE PROBLEM

Exchange Rate Behavior

Questions 1

As an employee of the foreign exchange department for a large company, you have been given the following information: Beginning of Year Spot rate of £ $1.596 Spot rate of Australian dollar (A$) $.70 Cross exchange rate: £1 A$2.28 One-year forward rate of A$ $.71 One-year forward rate of £ $1.58004 One-year U.S. interest rate 8.00% One-year British interest rate 9.09% One-year Australian interest rate 7.00%

Determine whether triangular arbitrage is feasible and, if so, how it should be conducted to make a proﬁt. 2 Using the information in question 1, determine whether covered interest arbitrage is feasible and, if so, how it should be conducted to make a proﬁt. 3 Based on the information in question 1 for the beginning of the year, use the international Fisher effect (IFE) theory to forecast the annual percentage change in the British pound’s value over the year. 4 Assume that at the beginning of the year, the pound’s value is in equilibrium. Assume that over the year the British inflation rate is 6 percent, while the U.S. inflation rate is 4 percent. Assume that any change in the pound’s value due to the inflation differential has occurred by the end of the year. Using this information and the information provided in question 1, determine how the pound’s value changed over the year. 5 Assume that the pound’s depreciation over the year was attributed directly to central bank intervention. Explain the type of direct intervention that would place downward pressure on the value of the pound.

240

Midterm Self Exam

Midterm Review You have just completed all the chapters focused on the macro- and market-related concepts. Here is a brief summary of some of the key points in those chapters. Chapter 1 explains the role of ﬁ nancial managers to focus on maximizing the value of the MNC and how that goal can be distorted by agency problems. MNCs use various incentives to ensure that managers serve shareholders rather than themselves. Chapter 1 explains that an MNC’s value is the present value of its future cash ﬂows and how a U.S.-based MNC’s value is inﬂuenced by its foreign cash ﬂows. Its dollar cash ﬂows (and therefore its value) are enhanced when the foreign currencies received appreciate against the dollar, or when foreign currencies of outﬂows depreciate. The MNC’s value is also inﬂuenced by its cost of capital, which is inﬂuenced by its capital structure and the risk of the projects that it pursues. The valuation is dependent on the environment in which MNCs operate along with their managerial decisions. Chapter 2 focuses on international transactions in a global context, with emphasis on international trade and capital ﬂows. International trade ﬂows are sensitive to relative prices of products between countries, while international capital ﬂows are inﬂuenced by the potential return on funds invested. They can have a major impact on the economic conditions of each country and the MNCs that operate there. Net trade ﬂows to a country may create more jobs there, while net capital ﬂows to a country can increase the amount of funds that can be channeled to ﬁ nance projects by ﬁ rms or government agencies. Chapter 3 introduces the international money, bond, and stock markets and explains how they facilitate the operations of MNCs. It also explains how the foreign exchange market facilitates international transactions. Chapter 4 explains how a currency’s direct exchange rate (value measured in dollars) may rise when its country has relatively low inﬂation and relatively high interest rates (if expected inﬂation is low) compared with the United States. Chapter 5 introduces currency derivatives and explains how they can be used by MNCs or individuals to capitalize on expected movements in exchange rates. Chapter 6 describes the role of central banks in the foreign exchange market and how they can use direct intervention to affect exchange rate movements. They can attempt to raise the value of their home currency by using dollars or another currency in their reserves to purchase their home currency in the foreign exchange market. The central banks can also attempt to reduce the value of their home currency by using their home currency reserves to purchase dollars in the foreign exchange market. Alternatively, they could use indirect intervention by affecting interest rates in a manner that will affect the appeal of their local money market securities relative to other

241

Midterm Self Exam

242

Midterm Self Exam

countries. This action affects the supply of their home currency for sale and/or the demand for their home currency in the foreign exchange market and therefore affects the exchange rate. Chapter 7 explains how the forces of arbitrage allow for parity conditions and more orderly foreign exchange market quotations. Speciﬁcally, locational arbitrage ensures that exchange rate quotations are similar among locations. Triangular arbitrage ensures that cross exchange rates are properly aligned. Covered interest arbitrage tends to ensure that the spot and forward exchange rates maintain a relationship that reﬂects interest rate parity, whereby the forward rate premium reﬂects the interest rate differential. Chapter 8 gives special attention to the impact of inﬂation and interest rates on exchange rate movements. Purchasing power parity suggests that a currency will depreciate to offset its country’s inﬂation differential above the United States (or will appreciate if its country’s inﬂation is lower than in the United States). The international Fisher effect suggests that if nominal interest rate differentials reﬂect the expected inﬂation differentials (the real interest rate is the same in each country), the exchange rate will move in accordance with purchasing power parity as applied to expected inﬂation. That is, a currency will depreciate to offset its country’s expected inﬂation differential above the United States (or will appreciate if its country’s expected inﬂation is lower than in the United States).

Midterm Self Exam This self exam allows you to test your understanding of some of the key concepts covered up to this point. Chapters 1 to 8 are macro- and market-oriented, while Chapters 9 to 21 are micro-oriented. This is a good opportunity to assess your understanding of the macro and market concepts, before moving on to the micro concepts in Chapters 9 to 21. This exam does not replace all the end-of-chapter self tests, nor does it test all the concepts that have been covered up to this point. It is simply intended to let you test yourself on a general overview of key concepts. Try to simulate taking an exam by answering all questions without using your book and your notes. The answers to this exam are provided just after the exam so that you can grade your exam. If you have any wrong answers, you should reread the related material and then redo any exam questions that you had wrong. This exam may not necessarily match the level of rigor in your course. Your instructor may offer you speciﬁc information about how this Midterm Self Exam relates to the coverage and rigor of the midterm exam in your course. 1. An MNC’s cash ﬂows and therefore its valuation can be affected by expected exchange rate movements (as explained in Chapter 1). Sanoma Co. is a U.S.-based MNC that wants to assess how its valuation is affected by expected exchange rate movements. Given Sanoma’s business transactions and its expectations of exchange rates, ﬁ ll out the table at the top of next page. 2. The United States has a larger balance-of-trade deﬁcit each year (as explained in Chapter 2). Do you think a weaker dollar would reduce the balance-of-trade deﬁcit? Offer a convincing argument for your answer. 3. Is outsourcing by U.S. ﬁ rms to foreign countries beneﬁcial to the U.S. economy? Weigh the pros and cons, and offer your conclusions. 4. a. The dollar is presently worth .8 euros. What is the direct exchange rate of the euro? b. The direct exchange rate of the euro is presently valued higher than it was last

month. What does this imply about the movement of the indirect exchange rate of the euro over the last month?

Midterm Self Exam

Currency Used in Transaction

Expected Movement in Currency’s Value against the U.S. Dollar during This Year

a. Import materials from Canada

Canadian dollar

Depreciate

b. Export products to Germany

Euro

Appreciate

c. Receive remitted earnings from its foreign subsidiary in Argentina

Argentine peso

Appreciate

d. Receive interest from its Australian cash account

Australian dollar

Depreciate

e. Make loan payments on a loan provided by a Japanese bank

Japanese yen

Depreciate

How the Expected Currency Movement Will Affect Sanoma’s Net Cash Flows (and Therefore Value) This Year

c. The Wall Street Journal quotes the Australian dollar to be worth $.50, while the one-year forward rate of the Australian dollar is $.51. What is the forward rate premium? What is the expected rate of appreciation (or depreciation) if the one-year forward rate is used to predict the value of the Australian dollar in one year?

5. Assume that the Polish currency (called zloty) is worth $.32. The U.S. dollar is worth .7 euros. A U.S. dollar can be exchanged for 8 Mexican pesos. Last year a dollar was valued at 2.9 Polish zloty, and the peso was valued at $.10. a. Would U.S. exporters to Mexico that accept pesos as payment be favorably or unfavorably affected by the change in the Mexican peso’s value over the last year? b. Would U.S. importers from Poland that pay for imports in zloty be favorably or unfavorably affected by the change in the zloty’s value over the last year? c. What is the percentage change in the cross exchange rate of the peso in zloty over the last year? How would ﬁ rms in Mexico that sell products to Poland denominated in zloty be affected by the change in the cross exchange rate?

6. Explain how each of the following conditions would be expected to affect the value of the Mexican peso.

Situation

Expected Impact on the Exchange Rate of the Peso

a. Mexico suddenly experiences a high rate of inﬂation. b. Mexico’s interest rates rise, while its inﬂation is expected to remain low. c. Mexico’s central bank intervenes in the foreign exchange market by purchasing dollars with pesos. d. Mexico imposes quotas on products imported from the United States.

7. One year ago, you sold a put option on 100,000 euros with an expiration date of one year. You received a premium on the put option of $.05 per unit. The exercise price was $1.22. Assume that one year ago, the spot rate of the euro was $1.20. One year ago, the one-year forward rate of the euro exhibited a discount of 2 percent, and the one-year futures price of the euro was the same as the one-year forward rate of the euro. From one year ago to today, the euro depreciated against the dollar by 4 percent. Today the put option will be exercised (if it is feasible for the buyer to do so). a. Determine the total dollar amount of your proﬁt or loss from your position in the put option.

Midterm Self Exam

Each Quarter during the Year, Sanoma’s Main Business Transactions Will Be to:

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244

Midterm Self Exam b. One year ago, Rita sold a futures contract on 100,000 euros with a settlement date

of one year. Determine the total dollar amount of her proﬁt or loss. 8. Assume that the Federal Reserve wants to reduce the value of the euro with respect to the dollar. How could it attempt to use indirect intervention to achieve its goal? What is a possible adverse effect from this type of intervention? 9. Assume that interest rate parity exists. The one-year nominal interest rate in the United States is 7 percent, while the one-year nominal interest rate in Australia is 11 percent. The spot rate of the Australian dollar is $.60. Today, you purchase a oneyear forward contract on 10 million Australian dollars. How many U.S. dollars will you need in one year to fulﬁ ll your forward contract? 10. You go to a bank and are given these quotes: You can buy a euro for 14 Mexican pesos. The bank will pay you 13 pesos for a euro. You can buy a U.S. dollar for .9 euros. The bank will pay you .8 euros for a U.S. dollar. You can buy a U.S. dollar for 10 pesos. The bank will pay you 9 pesos for a U.S. dollar. You have $1,000. Can you use triangular arbitrage to generate a proﬁt? If so, explain the order of the transactions that you would execute and the proﬁt that you would earn. If you cannot earn a proﬁt from triangular arbitrage, explain why. 11. Today’s spot rate of the Mexican peso is $.10. Assume that purchasing power parity holds. The U.S. inﬂation rate over this year is expected to be 7 percent, while the Mexican inﬂation over this year is expected to be 3 percent. Carolina Co. plans to import from Mexico and will need 20 million Mexican pesos in one year. Determine the expected amount of dollars to be paid by the Carolina Co. for the pesos in one year. 12. Tennessee Co. purchases imports that have a price of 400,000 Singapore dollars, and it has to pay for the imports in 90 days. It will use a 90-day forward contract to cover its payables. Assume that interest rate parity exists and will continue to exist. This morning, the spot rate of the Singapore dollar was $.50. At noon, the Federal Reserve reduced U.S. interest rates. There was no change in the Singapore interest rates. The Singapore dollar’s spot rate remained at $.50 throughout the day. But the Fed’s actions immediately increased the degree of uncertainty surrounding the future value of the Singapore dollar over the next 3 months. a. If Tennessee Co. locked in a 90-day forward contract this afternoon, would its to-

tal U.S. dollar cash outﬂows be more than, less than, or the same as the total U.S. dollar cash outﬂows if it had locked in a 90-day forward contract this morning? Brieﬂy explain. b. Assume that Tennessee uses a currency options contract to hedge rather than a

forward contract. If Tennessee Co. purchased a currency call option contract at the money on Singapore dollars this afternoon, would its total U.S. dollar cash outﬂows be more than, less than, or the same as the total U.S. dollar cash outﬂows if it had purchased a currency call option contract at the money this morning? Brieﬂy explain. c. Assume that the U.S. and Singapore interest rates were the same as of this morn-

ing. Also assume that the international Fisher effect holds. If Tennessee Co. purchased a currency call option contract at the money this morning to hedge its exposure, would you expect that its total U.S. dollar cash outﬂows would be more than, less than, or the same as the total U.S. dollar cash outﬂows if it had negotiated a forward contract this morning? Brieﬂy explain. 13. Today, a U.S. dollar can be exchanged for 3 New Zealand dollars or for 1.6 Canadian dollars. The one-year CD (deposit) rate is 7 percent in New Zealand, is 6 percent in the United States, and is 5 percent in Canada. Interest rate parity exists

Midterm Self Exam

245

Karen (based in the United States) invests in a one-year CD in New Zealand and sells New Zealand dollars one year forward to cover her position. Marcia (who lives in New Zealand) invests in a one-year CD in the United States and sells U.S. dollars one year forward to cover her position. William (who lives in Canada) invests in a one-year CD in the United States and does not cover his position. James (based in the United States) invests in a one-year CD in New Zealand and does not cover his position. Based on this information, which person will be expected to earn the highest return on the funds invested? If you believe that multiple persons will tie for the highest expected return, name each of them. Brieﬂy explain. 14. Assume that the United Kingdom has an interest rate of 8 percent, versus an interest rate of 5 percent in the United States. a. Explain what the implications are for the future value of the British pound according to the theory in Chapter 4 that a country with high interest rates may attract capital ﬂows versus the theory of the international Fisher effect (IFE) in Chapter 8. b. Compare the implications of the IFE from Chapter 8 versus interest rate parity (IRP) as related to the information provided here.

Answers to Midterm Self Exam 1. a. Increase b. Increase c. Increase d. Decrease e. Increase

2. One argument is that a weak dollar will make U.S. products imported by foreign countries cheaper, which will increase the demand for U.S. exports. In addition, a weaker dollar may discourage U.S. ﬁ rms from importing foreign products because the cost will be higher. Both factors result in a smaller balance-of-trade deﬁcit. However, a weak dollar might not improve the balance-of-trade deﬁcit because it is unlikely to weaken against all countries simultaneously. Foreign ﬁ rms may compare the price they would pay for U.S. products to the price paid for similar products in other countries. Even if the dollar weakens, products produced in China or some other countries where there is cheap labor may still be cheaper for customers based in the United States or other countries. 3. Outsourcing can be beneﬁcial to the U.S. economy because it may allow U.S. ﬁ rms to produce their products at a lower cost and increase their proﬁts (which increases income earned by the U.S. owners of those ﬁ rms). It also allows U.S. customers to purchase products and services at a lower cost. However, outsourcing eliminates some jobs in the United States, which reduces or eliminates income for people whose job was outsourced. The overall effect on the U.S. economy is based on a comparison of these two forces. It is possible to make arguments for either side. Also, the effects will vary depending on the location. For example, outsourcing may be more likely in a high-wage city in the United States where ﬁ rms provide services that can be handled by phone or by electronic interaction. These jobs are easier to outsource than some other jobs.

Midterm Self Exam

between the United States and New Zealand and between the United States and Canada. The international Fisher effect exists between the United States and New Zealand. You expect that the Canadian dollar will be worth $.61 at the end of one year.

Midterm Self Exam

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Midterm Self Exam

4. a. A euro $1.25. b. The indirect value of the euro must have declined over the last month. c. The forward premium is 2 percent. If the forward rate is used to forecast, the ex-

pected degree of appreciation over the next year is ($.51 $.50)/$.50 2%, which is the same as the forward rate premium. 5. a. The peso is valued at $.125 today. Since the peso appreciated, the U.S. exporters are favorably affected. b. The zloty was worth about $.345 last year. Since the zloty depreciated, the U.S.

importers were favorably affected. c. Last year, the cross rate of the peso in zloty $.10/$.345 .2898. Today, the

cross rate of the peso in zloty $.125/$.32 .391. The percentage change is (.391 .2898)/.2898 34.92%.

6. a. Depreciate b. Appreciate c. Depreciate d. Appreciate

7. a. The spot rate depreciated from $1.20 to $1.152. You receive $.05 per unit. The buyer of the put option exercises the option, and you buy the euros for $1.22 and sell them in the spot market for $1.152. Your gain on the put option per unit is ($1.152 $1.22) $.05 $.018. Total gain $.018 100,000 $1,800. b. The futures rate one year ago was equal to:

$1.20 (1 .02) $1.176. So the futures rate is $1.176. The gain per unit is $1.176 $1.152 $.024 and the total gain is $.024 100,000 $2,400. 8. The Fed could use indirect intervention by raising U.S. interest rates so that the United States would attract more capital ﬂows, which would place upward pressure on the dollar. However, the higher interest rates could make borrowing too expensive for some ﬁ rms, and would possibly reduce economic growth. 9. [(1.07)/(1.11)] 1 3.60%. So the one-year forward rate is $.60 [1 (.036)] $.5784. You will need 10,000,000 $.5784 $5,784,000. 10. Yes, you can generate a proﬁt by converting dollars to euros, and then euros to pesos, and then pesos to dollars. First convert the information to direct quotes:

Bid

Ask

Euro in $

1.11

1.25

Pesos in $

$.10

$.11

Euro in pesos

13

14

Use $1,000 to purchase euros: $1,000/1.25 800 euros. Convert 800 euros to buy pesos: 800 euros 13 10,400 pesos. Convert the 10,400 pesos to U.S. dollars: 10,400 $.10 $1,040. There is proﬁt of $40 on a $1,000 investment. The alternative strategy that you could attempt is to ﬁ rst buy pesos: Use $1,000 to purchase pesos: $1,000/$.11 9,090.9 pesos. Convert 9,090 pesos to euros: 9,090.9/14 649.35 euros. Convert 649.35 euros to dollars: 649.35 euros 1.11 $720.78. This strategy results in a loss.

Midterm Self Exam

247

12. a. Less than because the discount would be more pronounced or the forward premium would be reduced. b. More than because the option premium increased due to more uncertainty. c. More than because there is an option premium on the option and the forward rate has no premium in this example, and the expectation is that the future spot rate will be no higher than today’s forward rate. The option is at the money so exercise price is same as expected spot rate but you have to pay the option premium.

13. The expected returns of each person are as follows: Karen earns 6 percent due to interest rate parity, and earns the same return as what she could earn locally. Marcia earns 7 percent due to interest rate parity, and earns the same return as what she could earn locally. William earns 8.6 percent. If he converts, C$ $.625 today. After one year, C$ $.61. So if William invests C$1,000, it converts to $625. At the end of one year, he has $662.50. He converts to C$ and has C$1,086. James is expected to earn 6 percent, since the international Fisher effect (IFE) suggests that on average, the exchange rate movement will offset the interest rate differential. 14. a. The IFE disagrees with the theory from Chapter 4 that a currency will appreciate if it has a high interest rate (holding other factors such as inﬂation constant). The IFE says that capital ﬂows will not go to where the interest rate is higher because the higher interest rate reﬂects a higher expectation of inﬂation, which means the currency will weaken over time. If you believe the higher interest rate reﬂects higher expected inﬂation, then the IFE makes sense. However, in many cases (such as this case), a higher interest rate may be caused by reasons other than inﬂation (perhaps the U.K. economy is strong and many ﬁ rms are borrowing money right now) and if so, then there is no reason to think the currency will depreciate in the future. Therefore, the IFE would not make sense. The key is that you can see the two different arguments, so that you can understand why a high interest rate may lead to local currency depreciation in some cases and appreciation in other cases. b. If U.S. investors attempt to capitalize on the higher rate without covering, they do not know what their return will be. However, if they believe in the IFE, then this means that the United Kingdom’s higher interest rate of 3 percent above the United States reﬂects a higher expected inﬂation rate in the United Kingdom of about 3 percent. This implies that the best guess of the change in the pound will be 3 percent for the pound (since the IFE relies on PPP), which means that the best guess of the U.S. investor return is about 5 percent, the same as is possible domestically. It may be better, it may be worse, but on average, it is not expected to be any better than what investors can get locally. The IFE is focused on situations in which you are trying to anticipate the movement in a currency and you know the interest rate differentials. Interest rate parity uses interest rate differentials to derive forward rate. The oneyear forward rate would be exactly equal to the expected future spot rate if you use the IFE to derive a best guess of the future spot rate in one year. But if you invest and cover with the forward rate, you know exactly what your outcome will be. If you invest and do not cover, the IFE gives you a prediction of what the outcome will be, but it is just a guess. The result could be 20 percent above or below that guess or even farther away from the guess.

Midterm Self Exam

11. [(1.07)/(1.03)] 1 3.8835%. So the expected future spot rate is $.1038835. Carolina will need to pay $.1038835 20 million pesos $2,077,670.

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Part Part3: 1: Exchange Overview of Rate the Risk Financial Management Environment Part 3 (Chapters 9 through 12) explains the various functions involved in managing exposure to exchange rate risk. Chapter 9 describes various methods used to forecast exchange rates and explains how to assess forecasting performance. Chapter 10 demonstrates how to measure exposure to exchange rate movements. Given a ﬁrm’s exposure and forecasts of future exchange rates, Chapters 11 and 12 explain how to hedge that exposure.

Information on Existing and Anticipated Economic Conditions of Various Countries and on Historical Exchange Rate Movements

Information on Existing and Anticipated Cash Flows in Each Currency at Each Subsidiary

Forecasting Exchange Rates Managing Exposure to Exchange Rate Fluctuations • How Exposure Will Affect Cash Flows Based on Forecasted Exchange Rates • Whether to Hedge Any of the Exposure and Which Hedging Technique to Use

Measuring Exposure to Exchange Rate Fluctuations

9: Forecasting Exchange Rates Many decisions of MNCs are inﬂuenced by exchange rate projections. Financial managers must understand how to forecast exchange rates so that they can make decisions that maximize the value of their MNCs.

■ describe the common techniques used for forecast-

ing, and ■ explain how forecasting performance can be

evaluated.

The speciﬁc objectives of this chapter are to: ■ explain how ﬁrms can beneﬁt from forecasting ex-

change rates,

Why Firms Forecast Exchange Rates Virtually every operation of an MNC can be inﬂuenced by changes in exchange rates. The following are some of the corporate functions for which exchange rate forecasts are necessary: • Hedging decision. MNCs constantly face the decision of whether to hedge future payables and receivables in foreign currencies. Whether a ﬁrm hedges may be determined by its forecasts of foreign currency values. Laredo Co., based in the United States, plans to pay for clothing imported from Mexico in 90 days. If the forecasted value of the peso in 90 days is sufﬁciently below the 90-day forward rate, the MNC may decide not to hedge. Forecasting may enable the ﬁrm to make a decision that will increase its cash ﬂows. ■

E X A M P L E

• Short-term ﬁnancing decision. When large corporations borrow, they have access to several different currencies. The currency they borrow will ideally (1) exhibit a low interest rate and (2) weaken in value over the ﬁnancing period. Westbury Co. considers borrowing Japanese yen to ﬁnance its U.S. operations because the yen has a low interest rate. If the yen depreciates against the U.S. dollar over the ﬁnancing period, the ﬁrm can pay back the loan with fewer dollars (when converting those dollars in exchange for the amount owed in yen). The decision of whether to ﬁnance with yen or dollars is dependent on a forecast of the future value of the yen. ■

E X A M P L E

• Short-term investment decision. Corporations sometimes have a substantial amount of excess cash available for a short time period. Large deposits can be established in several currencies. The ideal currency for deposits will (1) exhibit a high interest rate and (2) strengthen in value over the investment period.

250

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251

Lafayette Co. has excess cash and considers depositing the cash into a British bank account. If the British pound appreciates against the dollar by the end of the deposit period when pounds will be withdrawn and exchanged for U.S. dollars, more dollars will be received. Thus, the ﬁrm can use forecasts of the pound’s exchange rate when determining whether to invest the short-term cash in a British account or a U.S. account. ■

E X A M P L E

• Capital budgeting decision. When an MNC’s parent assesses whether to invest funds in a foreign project, the ﬁrm takes into account that the project may periodically require the exchange of currencies. The capital budgeting analysis can be completed only when all estimated cash ﬂows are measured in the parent’s local currency. Evansville Co. wants to determine whether to establish a subsidiary in Thailand. Forecasts of the future cash ﬂows used in the capital budgeting process will be dependent on the future exchange rate of Thailand’s currency (the baht) against the dollar. This dependency can be due to (1) future inﬂows denominated in baht that will require conversion to dollars and/or (2) the inﬂuence of future exchange rates on demand for the subsidiary’s products. Accurate forecasts of currency values will improve the estimates of the cash ﬂows and therefore enhance the MNC’s decision making. ■

E X A M P L E

• Earnings assessment. The parent’s decision about whether a foreign subsidiary should reinvest earnings in a foreign country or remit earnings back to the parent may be inﬂuenced by exchange rate forecasts. If a strong foreign currency is expected to weaken substantially against the parent’s currency, the parent may prefer to expedite the remittance of subsidiary earnings before the foreign currency weakens. Exchange rate forecasts are also useful for forecasting an MNC’s earnings. When earnings of an MNC are reported, subsidiary earnings are consolidated and translated into the currency representing the parent ﬁrm’s home country. DuPont has a large amount of business in Europe. Its forecast of consolidated earnings requires a forecast of earnings generated by subsidiaries in each country along with a forecast of the exchange rate at which those earnings will be translated into dollars (in order to consolidate all earnings into a single currency). Given the uncertainty of exchange rates and other factors that affect earnings, DuPont uses a range when forecasting its earnings. The low end allows for the possibility of a weak euro (European earnings translated at low exchange rates), while the high end allows for the possibility of a strong euro (European earnings translated at high exchange rates). ■

E X X A M P L E

For accounting purposes, DuPont’s European subsidiaries’ earnings in euros must be measured by translating them to U.S. dollars. Its British subsidiary’s earnings in pounds must also be measured by translation to U.S. dollars. “Translation” does not mean that the earnings are physically converted to U.S. dollars. It is simply a periodic recording process so that consolidated earnings can be reported in a single currency. In this case, appreciation of the euro will boost the European subsidiaries’ earnings when they are reported in (translated to) U.S. dollars. Forecasts of exchange rates thus play an important role in the overall forecast of an MNC’s consolidated earnings. • Long-term ﬁnancing decision. Corporations that issue bonds to secure long-term funds may consider denominating the bonds in foreign currencies. They prefer that the currency borrowed depreciate over time against the currency they are receiving from sales. To estimate the cost of issuing bonds denominated in a foreign currency, forecasts of exchange rates are required.

252

Part 3: Exchange Rate Risk Management Bryce Co. needs long-term funds to support its U.S. business. It can issue 10-year bonds denominated in Japanese yen at a 1 percent coupon rate, which is 5 percentage points less than the prevailing coupon rate on dollar-denominated bonds. However, Bryce will need to convert dollars to make the coupon or principal payments on the yen-denominated bond, so if the yen’s value rises, the yen-denominated bond could be more costly to Bryce than the U.S. bond. Bryce’s decision to issue yen-denominated bonds versus dollar-denominated bonds will be dependent on its forecast of the yen’s exchange rate over the 10-year period. ■

E X A M P L E

Most forecasting is applied to currencies whose exchange rates ﬂuctuate continuously, and that is the focus of this chapter. However, some forecasts are also derived for currencies whose exchange rates are ﬁxed. Even though the Argentine peso’s value was still tied to the U.S. dollar in 2001, some U.S.-based MNCs created forecasts for the peso at that time because they anticipated that it would be devalued. The peso was devalued in 2002, and its exchange rate is no longer tied to the U.S. dollar. The Hong Kong dollar has been tied to the U.S. dollar since 1983, but some MNCs still prepare long-term forecasts of the Hong Kong dollar in anticipation that it may be revalued. ■

E X A M P L E

An MNC’s motives for forecasting exchange rates are summarized in Exhibit 9.1. The motives are distinguished according to whether they can enhance the MNC’s value by inﬂuencing its cash ﬂows or its cost of capital. The need for accurate exchange rate projections should now be clear. The following section describes the forecasting methods available.

Forecasting Techniques The numerous methods available for forecasting exchange rates can be categorized into four general groups: (1) technical, (2) fundamental, (3) market based, and (4) mixed. Exhibit 9.1

Corporate Motives for Forecasting Exchange Rates

Decide Whether to Hedge Foreign Currency Cash Flows

Decide Whether to Invest in Foreign Projects Forecasting Exchange Rates

Dollar Cash Flows

Decide Whether Foreign Subsidiaries Should Remit Earnings

Decide Whether to Obtain Financing in Foreign Currencies

Value of the Firm

Cost of Capital

Chapter 9: Forecasting Exchange Rates

253

Technical Forecasting Technical forecasting involves the use of historical exchange rate data to predict future values. There may be a trend of successive daily exchange rate adjustments in the same direction, which could lead to a continuation of that trend. Alternatively, there may be a trend of the average daily change in the exchange rate per week over several recent weeks. A trend of higher mean daily exchange rate adjustments on a weekly basis may indicate that the exchange rate will continue to appreciate in the future. Alternatively, there may be some technical indicators that a correction in the exchange rate is likely, which would result in a forecast that the exchange rate will reverse its direction.

Tomorrow Kansas Co. has to pay 10 million Mexican pesos for supplies that it recently received from Mexico. Today, the peso has appreciated by 3 percent against the dollar. Kansas Co. could send the payment today so that it would avoid the effects of any additional appreciation tomorrow. Based on an analysis of historical time series, Kansas has determined that whenever the peso appreciates against the dollar by more than 1 percent, it experiences a reversal of about 60 percent of that change on the following day. That is,

E X A M P L E

et11 5 et 3 1 260% 2 when et . 1% Applying this tendency to the current situation in which the peso appreciated by 3 percent today, Kansas Co. forecasts that tomorrow’s exchange rate will change by

et11 5 et 3 1 260% 2 5 1 3% 2 3 1 260% 2 5 21.8% Given this forecast that the peso will depreciate tomorrow, Kansas Co. decides that it will make its payment tomorrow instead of today. ■

Technical factors are sometimes cited as the main reason for changing speculative positions that cause an adjustment in the dollar’s value. For example, headlines often attribute a change in the dollar’s value to technical factors: • Technical factors overwhelmed economic news. • Technical factors triggered sales of dollars. • Technical factors indicated that dollars had been recently oversold, triggering purchases of dollars.

H T T P : // http://www.ny.frb.org/ markets/foreignex.html Historical exchange rate data that may be used to create technical forecasts of exchange rates.

Limitations of Technical Forecasting. MNCs tend to make only limited use of technical forecasting because it typically focuses on the near future, which is not very helpful for developing corporate policies. Most technical forecasts apply to very short-term periods such as one day because patterns in exchange rate movements are more systematic over such periods. Since patterns may be less reliable for forecasting long-term movements over a quarter, a year, or 5 years from now, technical forecasts are less useful for forecasting exchange rates in the distant future. Thus, technical forecasting may not be suitable for ﬁrms that need to forecast exchange rates in the distant future. In addition, technical forecasting rarely provides point estimates or a range of possible future values. Because technical analysis typically cannot estimate future exchange rates in precise terms, it is not, by itself, an adequate forecasting tool for ﬁnancial managers of MNCs.

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Part 3: Exchange Rate Risk Management

A technical forecasting model that has worked well in one particular period will not necessarily work well in another. With the abundance of technical models existing today, some are bound to generate speculative proﬁts in any given period. If the pattern of currency values over time appears to be random, then technical forecasting is not appropriate. Unless historical trends in exchange rate movements can be identiﬁed, examination of past movements will not be useful for indicating future movements. Many foreign exchange participants argue that even if a particular technical forecasting model is shown to lead consistently to speculative proﬁts, it will no longer be useful once other participants begin to use it. Trading based on the model’s recommendation will push the currency value to a new position immediately. Speculators using technical exchange rate forecasting often incur large transaction costs due to their frequent trading. In addition, monitoring currency movements in search of a systematic pattern can be time-consuming. Furthermore, speculators need sufﬁcient capital to absorb losses that may occur.

Fundamental Forecasting Fundamental forecasting is based on fundamental relationships between economic variables and exchange rates. Recall from Chapter 4 that a change in a currency’s spot rate is inﬂuenced by the following factors:

e f (DINF, DINT, DINC, DGC, DEXP) where e percentage change in the spot rate DINF change in the differential between U.S. inﬂation and the foreign country’s inﬂation DINT change in the differential between the U.S. interest rate and the foreign country’s interest rate DINC change in the differential between the U.S. income level and the foreign country’s income level DGC change in government controls DEXP change in expectations of future exchange rates Given current values of these variables along with their historical impact on a currency’s value, corporations can develop exchange rate projections. A forecast may arise simply from a subjective assessment of the degree to which general movements in economic variables in one country are expected to affect exchange rates. From a statistical perspective, a forecast would be based on quantitatively measured impacts of factors on exchange rates. Although some of the fullblown fundamental models are beyond the scope of this text, a simpliﬁed discussion follows. The focus here is on only two of the many factors that affect currency values. Before identifying them, consider that the corporate objective is to forecast the percentage change (rate of appreciation or depreciation) in the British pound with respect to the U.S. dollar during the next quarter. For simplicity, assume the firm’s forecast for the British pound is dependent on only two factors that affect the pound’s value:

E X A M P L E

1. Inflation in the United States relative to inflation in the United Kingdom. 2. Income growth in the United States relative to income growth in the United Kingdom (measured as a percentage change). The first step is to determine how these variables have affected the percentage change in the pound’s value based on historical data. This is commonly achieved with regression

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analysis. First, quarterly data are compiled for the inflation and income growth levels of both the United Kingdom and the United States. The dependent variable is the quarterly percentage change in the British pound value (called BP). The independent (influential) variables may be set up as follows: 1. Previous quarterly percentage change in the inflation differential (U.S. inflation rate minus British inflation rate), referred to as INFt1. 2. Previous quarterly percentage change in the income growth differential (U.S. income growth minus British income growth), referred to as INCt1. The regression equation can be defined as

BPt 5 b0 1 b1INFt21 1 b2INCt21 1 mt where b0 is a constant, b1 measures the sensitivity of BPt to changes in INFt1, b2 measures the sensitivity of BPt to changes in INCt1, and mt represents an error term. A set of historical data is used to obtain previous values of BP, INF, and INC. Using this data set, regression analysis will generate the values of the regression coefficients (b0, b1, and b2). That is, regression analysis determines the direction and degree to which BP is affected by each independent variable. The coefficient b1 will exhibit a positive sign if, when INFt1 changes, BPt changes in the same direction (other things held constant). A negative sign indicates that BPt and INFt1 move in opposite directions. In the equation given, b1 is expected to exhibit a positive sign because when U.S. inflation increases relative to inflation in the United Kingdom, upward pressure is exerted on the pound’s value. The regression coefficient b2 (which measures the impact of INCt1 on BPt) is expected to be positive because when U.S. income growth exceeds British income growth, there is upward pressure on the pound’s value. These relationships have already been thoroughly discussed in Chapter 4. Once regression analysis is employed to generate values of the coefficients, these coefficients can be used to forecast. To illustrate, assume the following values: b0 .002, b1 .8, and b2 1.0. The coefficients can be interpreted as follows. For a one-unit percentage change in the inflation differential, the pound is expected to change by .8 percent in the same direction, other things held constant. For a one-unit percentage change in the income differential, the British pound is expected to change by 1.0 percent in the same direction, other things held constant. To develop forecasts, assume that the most recent quarterly percentage change in INFt1 (the inflation differential) is 4 percent and that INCt1 (the income growth differential) is 2 percent. Using this information along with our estimated regression coefficients, the forecast for BPt is

BPt 5 b0 1 b1INFt21 1 b2INCt21 5 .002 1 .8 1 4% 2 1 1 1 2% 2 5 .2% 1 3.2% 1 2% 5 5.4% Thus, given the current figures for inflation rates and income growth, the pound should appreciate by 5.4 percent during the next quarter. ■

This example is simpliﬁed to illustrate how fundamental analysis can be implemented for forecasting. A full-blown model might include many more than two factors, but the application would still be similar. A large time-series database would be necessary to warrant any conﬁdence in the relationships detected by such a model.

Use of Sensitivity Analysis for Fundamental Forecasting. When a regression model is used for forecasting, and the values of the inﬂuential factors have a lagged impact on exchange rates, the actual value of those factors can be

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used as input for the forecast. For example, if the inﬂation differential has a lagged impact on exchange rates, the inﬂation differential in the previous period may be used to forecast the percentage change in the exchange rate over the future period. Some factors, however, have an instantaneous inﬂuence on exchange rates. Since these factors obviously cannot be known, forecasts must be used. Firms recognize that poor forecasts of these factors can cause poor forecasts of the exchange rate movements, so they may attempt to account for the uncertainty by using sensitivity analysis, which considers more than one possible outcome for the factors exhibiting uncertainty. Phoenix Corp. develops a regression model to forecast the percentage change in the Mexican peso’s value. It believes that the real interest rate differential and the inflation differential are the only factors that affect exchange rate movements, as shown in this regression model:

E X A M P L E

et 5 a0 1 a1INTt 1 a2INFt21 1 mt where et percentage change in the peso’s exchange rate over period t INTt real interest rate differential over period t INFt1 inflation differential in the previous period t a0, a1, a2 regression coefficients mt error term Historical data are used to determine values for et along with values for INTt and INFt1 for several periods (preferably, 30 or more periods are used to build the database). The length of each historical period (quarter, month, etc.) should match the length of the period for which the forecast is needed. The historical data needed per period for the Mexican peso model are (1) the percentage change in the peso’s value, (2) the U.S. real interest rate minus the Mexican real interest rate, and (3) the U.S. inflation rate in the previous period minus the Mexican inflation rate in the previous period. Assume that regression analysis has provided the following estimates for the regression coefficients: Regression Coefﬁcient

Estimate

a0

.001

a1

.7

a2

.6

The negative sign of a1 indicates a negative relationship between INTt and the peso’s movements, while the positive sign of a2 indicates a positive relationship between INFt1 and the peso’s movements. To forecast the peso’s percentage change over the upcoming period, INTt and INFt1 must be estimated. Assume that INFt1 was 1 percent. However, INTt is not known at the beginning of the period and must therefore be forecasted. Assume that Phoenix Corp. has developed the following probability distribution for INTt: Probability

Possible Outcome

20%

3%

50%

4%

30%

5%

100%

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A separate forecast of et can be developed from each possible outcome of INTt as follows: Forecast of INT

Forecast of et

Probability

3%

.1% (.7)(3%) .6(1%) 2.8%

20%

4%

.1% (.7)(4%) .6(1%) 3.5%

50%

5%

.1% (.7)(5%) .6(1%) 4.2%

30%

■

If the ﬁ rm needs forecasts for other currencies, it can develop the probability distributions of their movements over the upcoming period in a similar manner. Phoenix Corp. can forecast the percentage change in the Japanese yen by regressing historical percentage changes in the yen’s value against (1) the differential between U.S. real interest rates and Japanese real interest rates and (2) the differential between U.S. inflation in the previous period and Japanese inflation in the previous period. The regression coefficients estimated by regression analysis for the yen model will differ from those for the peso model. The firm can then use the estimated coefficients along with estimates for the interest rate differential and inflation rate differential to develop a forecast of the percentage change in the yen. Sensitivity analysis can be used to reforecast the yen’s percentage change based on alternative estimates of the interest rate differential. ■

E X A M P L E

Use of PPP for Fundamental Forecasting. Recall that the theory of purchasing power parity (PPP) speciﬁes the fundamental relationship between the inﬂation differential and the exchange rate. In simple terms, PPP states that the currency of the relatively inﬂated country will depreciate by an amount that reﬂects that country’s inﬂation differential. Recall that according to PPP, the percentage change in the foreign currency’s value (e) over a period should reﬂect the differential between the home inﬂation rate (Ih) and the foreign inﬂation rate (If) over that period. The U.S. inflation rate is expected to be 1 percent over the next year, while the Australian inflation rate is expected to be 6 percent. According to PPP, the Australian dollar’s exchange rate should change as follows:

E X A M P L E

ef 5 5

1 1 IU.S. 21 1 1 If 1.01 21 1.06

> 24.7% This forecast of the percentage change in the Australian dollar can be applied to its existing spot rate to forecast the future spot rate at the end of one year. If the existing spot rate (St) of the Australian dollar is $.50, the expected spot rate at the end of one year, E(St1), will be about $.4765:

E 1 St11 2 5 St 1 1 1 ef 2 5 $.50 3 1 1 1 2.047 2 4 5 $.4765

■

In reality, the inﬂation rates of two countries over an upcoming period are uncertain and therefore would have to be forecasted when using PPP to forecast the future exchange rate at the end of the period. This complicates the use of PPP to forecast

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future exchange rates. Even if the inﬂation rates in the upcoming period were known with certainty, PPP might not be able to forecast exchange rates accurately. If the PPP theory were accurate in reality, there would be no need to even consider alternative forecasting techniques. However, using the inﬂation differential of two countries to forecast their exchange rate is not always accurate. Problems arise for several reasons: (1) the timing of the impact of inﬂation ﬂuctuations on changing trade patterns, and therefore on exchange rates, is not known with certainty; (2) data used to measure relative prices of two countries may be somewhat inaccurate; (3) barriers to trade can disrupt the trade patterns that should emerge in accordance with PPP theory; and (4) other factors, such as the interest rate differential between countries, can also affect exchange rates. For these reasons, the inﬂ ation differential by itself is not sufﬁcient to accurately forecast exchange rate movements. Nevertheless, it should be included in any fundamental forecasting model.

Limitations of Fundamental Forecasting. Although fundamental forecasting accounts for the expected fundamental relationships between factors and currency values, the following limitations exist: 1. The precise timing of the impact of some factors on a currency’s value is not known. It is possible that the full impact of factors on exchange rates will not occur until two, three, or four quarters later. The regression model would need to be adjusted accordingly. 2. As mentioned earlier, some factors exhibit an immediate impact on exchange rates. They can be usefully included in a fundamental forecasting model only if forecasts can be obtained for them. Forecasts of these factors should be developed for a period that corresponds to the period for which a forecast of exchange rates is necessary. In this case, the accuracy of the exchange rate forecasts will be somewhat dependent on the accuracy of these factors. Even if a ﬁ rm knows exactly how movements in these factors affect exchange rates, its exchange rate projections may be inaccurate if it cannot predict the values of the factors. 3. Some factors that deserve consideration in the fundamental forecasting process cannot be easily quantiﬁed. For example, what if large Australian exporting ﬁ rms experience an unanticipated labor strike, causing shortages? This will reduce the availability of Australian goods for U.S. consumers and therefore reduce U.S. demand for Australian dollars. Such an event, which would put downward pressure on the Australian dollar value, normally is not incorporated into the forecasting model. 4. Coefﬁcients derived from the regression analysis will not necessarily remain constant over time. In the previous example, the coefﬁcient for INFt1 was .6, suggesting that for a one-unit change in INFt1, the Mexican peso would appreciate by .6 percent. Yet, if the Mexican or U.S. governments imposed new trade barriers, or eliminated existing barriers, the impact of the inﬂation differential on trade (and therefore on the Mexican peso’s exchange rate) could be affected. These limitations of fundamental forecasting have been discussed to emphasize that even the most sophisticated forecasting techniques (fundamental or otherwise) cannot provide consistently accurate forecasts. MNCs that develop forecasts must allow for some margin of error and recognize the possibility of error when implementing corporate policies.

Market-Based Forecasting The process of developing forecasts from market indicators, known as market-based forecasting, is usually based on either (1) the spot rate or (2) the forward rate.

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259

Use of the Spot Rate. Today’s spot rate may be used as a forecast of the spot rate that will exist on a future date. To see why the spot rate can be a useful market-based forecast, assume the British pound is expected to appreciate against the dollar in the very near future. This expectation will encourage speculators to buy the pound with U.S. dollars today in anticipation of its appreciation, and these purchases can force the pound’s value up immediately. Conversely, if the pound is expected to depreciate against the dollar, speculators will sell off pounds now, hoping to purchase them back at a lower price after they decline in value. Such actions can force the pound to depreciate immediately. Thus, the current value of the pound should reﬂect the expectation of the pound’s value in the very near future. Corporations can use the spot rate to forecast since it represents the market’s expectation of the spot rate in the near future.

Use of the Forward Rate. A forward rate quoted for a speciﬁc date in H T T P : // http://www.cme.com Quotes on currency futures that can be used to create market-based forecasts.

the future is commonly used as the forecasted spot rate on that future date. That is, a 30-day forward rate provides a forecast for the spot rate in 30 days, a 90-day forward rate provides a forecast of the spot rate in 90 days, and so on. Recall that the forward rate is measured as F S(1 p) where p represents the forward premium. Since p represents the percentage by which the forward rate exceeds the spot rate, it serves as the expected percentage change in the exchange rate: E1e2 5 p 5 1 F/S 2 2 1 3 by rearranging terms 4

E X X A M P L E

If the one-year forward rate of the Australian dollar is $.63, while the spot rate is $.60, the expected percentage change in the Australian dollar is

E1e2 5 p 5 1 F/S 2 2 1 5 1 .63/.60 2 2 1 5 .05, or 5%

■

Rationale for Using the Forward Rate. To understand why the forward rate can serve as a forecast of the future spot rate, consider the following example. If speculators expect the spot rate of the British pound in 30 days to be $1.45, and the prevailing forward rate is $1.40, they might buy pounds 30 days forward at $1.40 and then sell them when received (in 30 days) at the spot rate existing then. If a large number of speculators implement this strategy, the substantial forward purchases of pounds will cause the forward rate to increase until this speculative demand stops. Perhaps this speculative demand will terminate when the forward rate reaches $1.45, since at this rate no profits will be expected by implementing the strategy. Thus, the forward rate should move toward the market’s general expectation of the future spot rate. In this sense, the forward rate serves as a market-based forecast since it reflects the market’s expectation of the spot rate at the end of the forward horizon (30 days from now in this example). ■

E X X A M P L E

Although the focus of this chapter is on corporate forecasting rather than speculation, it is speculation that helps to push the forward rate to the level that reﬂects the

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general expectation of the future spot rate. If corporations are convinced that the forward rate is a reliable indicator of the future spot rate, they can simply monitor this publicly quoted rate to develop exchange rate projections.

Long-Term Forecasting with Forward Rates. Long-term exchange rate forecasts can be derived from long-term forward rates. Assume that the spot rate of the euro is currently $1.00, while the 5-year forward rate of the euro is $1.06. This forward rate can serve as a forecast of $1.06 for the euro in 5 years, which reflects a 6 percent appreciation in the euro over the next 5 years. ■

E X A M P L E

Forward rates are normally available for periods of 2 to 5 years or even longer, but the bid/ask spread is wide because of the limited trading volume. Although such rates are rarely quoted in ﬁ nancial newspapers, the quoted interest rates on risk-free instruments of various countries can be used to determine what the forward rates would be under conditions of interest rate parity. The U.S. 5-year interest rate is currently 10 percent, annualized, while the British 5-year interest rate is 13 percent. The 5-year compounded return on investments in each of these countries is computed as follows:

E X A M P L E

Country

Five-Year Compounded Return

United States

(1.10)5 1 61%

United Kingdom

(1.13)5 1 84%

Thus, the appropriate 5-year forward rate premium (or discount) of the British pound would be

p5 5

1 1 iU.S. 21 1 1 iU.K. 1.61 21 1.84

5 2.125, or 212.5%

H T T P : // http://www .bmonesbittburns.com/ economics/fxrates Forward rates for the euro, British pound, Canadian dollar, and Japanese yen for 1-month, 3-month, 6-month, and 12-month maturities. These forward rates may serve as forecasts of future spot rates.

The results of this comparison suggest that the 5-year forward rate of the pound should contain a 12.5 percent discount. That is, the spot rate of the pound is expected to depreciate by 12.5 percent over the 5-year period for which the forward rate is used to forecast. ■

The governments of some emerging markets (such as those in Latin America) do not issue long-term ﬁ xed-rate bonds very often. Consequently, long-term interest rates are not available, and long-term forward rates cannot be derived in the manner shown here. The forward rate is easily accessible and therefore serves as a convenient and free forecast. Like any method of forecasting exchange rates, the forward rate is typically more accurate when forecasting exchange rates for short-term horizons than for longterm horizons. Exchange rates tend to wander farther from expectations over longer periods of time.

Implications of the IFE and IRP for Forecasts Using the Forward Rate. Recall that if interest rate parity (IRP) holds, the forward rate premium reﬂects the interest rate differential between two countries. Also recall that if the international Fisher effect (IFE) holds, a currency that has a higher interest rate than the U.S. interest rate should depreciate against the dollar because the higher

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261

interest rate implies a higher level of expected inﬂation in that country than in the United States. Since the forward rate captures the nominal interest rate (and therefore the expected inﬂation rate) between two countries, it should provide more accurate forecasts for currencies in high-inﬂation countries than the spot rate. Alves, Inc., is a U.S. firm that does business in Brazil, and it needs to forecast the exchange rate of the Brazilian real for one year ahead. It considers using either the spot rate or the forward rate to forecast the real. The spot rate of the Brazilian real is $.40. The one-year interest rate in Brazil is 20 percent, versus 5 percent in the United States. The oneyear forward rate is $.35, which reflects a discount to offset the interest rate differential according to IRP (check this yourself). Alves believes that the future exchange rate of the real will be driven by the inflation differential between Brazil and the United States. It also believes that the real rate of interest in both Brazil and the United States is 3 percent. This implies that the expected inflation rate for next year is 17 percent in Brazil and 2 percent in the United States. The forward rate discount is based on the interest rate differential, which in turn is related to the inflation differential. In this example, the forward rate of the Brazilian real reflects a large discount, which means that it implies a forecast of substantial depreciation of the real. Conversely, using the spot rate of the real as a forecast would imply that the exchange rate at the end of the year will be what it is today. Since the forward rate forecast indirectly captures the differential in expected inflation rates, it is a more appropriate forecast method than the spot rate. ■

E X X A M P L E

Firms may not always believe that the forward rate provides more accurate forecasts than the spot rate. If a ﬁ rm is forecasting over a very short term horizon such as a day or a week, the interest rate (and therefore expected inﬂation) differential may not be as inﬂuential. Second, some ﬁ rms may believe that the interest rate differential may not even be inﬂuential in the long run. Third, if the foreign country’s interest rate is usually similar to the U.S. rate, the forward rate premium or discount will be close to zero, meaning that the forward rate and spot rate will provide similar forecasts.

Mixed Forecasting Because no single forecasting technique has been found to be consistently superior to the others, some MNCs prefer to use a combination of forecasting techniques. This method is referred to as mixed forecasting. Various forecasts for a particular currency value are developed using several forecasting techniques. The techniques used are assigned weights in such a way that the weights total 100 percent, with the techniques considered more reliable being assigned higher weights. The actual forecast of the currency is a weighted average of the various forecasts developed. College Station, Inc., needs to assess the value of the Mexican peso because it is considering expanding its business in Mexico. The conclusions drawn from each forecasting technique are shown in Exhibit 9.2. Notice that, in this example, the forecasted direction of the peso’s value is dependent on the technique used. The fundamental forecast predicts the peso will appreciate, but the technical forecast and the market-based forecast predict it will depreciate. Also, notice that even though the fundamental and market-based forecasts are both driven by the same factor (interest rates), the results are distinctly different. ■

E X X A M P L E

Sometimes MNCs assign one technique a lower weight when forecasting in one period, but a higher weight when forecasting in a later period. Some ﬁ rms even weight a given technique more for some currencies than for others at a given point in time. For example, a ﬁ rm may decide that a market-based forecast provides the best prediction for the pound, but that fundamental forecasting works best for the New Zealand dollar, and technical forecasting for the Mexican peso.

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Exhibit 9.2

Forecasts of the Mexican Peso Drawn from Each Forecasting Technique Factors Considered

Situation

Forecast

Technical Forecast

Recent movement in peso

The peso’s value declined below a speciﬁc threshold level in the last few weeks.

The peso’s value will continue to fall now that it is beyond the threshold level.

Fundamental Forecast

Economic growth, inﬂation, interest rates

Mexico’s interest rates are high, and inﬂation should remain low.

The peso’s value will rise as U.S. investors capitalize on the high interest rates by investing in Mexican securities.

Market-Based Forecast

Spot rate, forward rate

The peso’s forward rate exhibits a signiﬁcant discount, which is attributed to Mexico’s relatively high interest rates.

Based on the forward rate, which provides a forecast of the future spot rate, the peso’s value will decline.

While each forecasting method has its merits, some changes in exchange rates are not anticipated by any method. During the Asian crisis, the Indonesian rupiah depreciated by more than 80 percent against the dollar within a 9-month period. Before the rupiah’s decline, neither technical factors, nor fundamental factors, nor the forward rate indicated any potential weakness. The depreciation of the rupiah was primarily attributed to concerns by institutional investors about the safety of their investments in Indonesia, which encouraged them to liquidate the investments and convert the rupiah into other currencies, putting downward pressure on the rupiah. ■

E X A M P L E

H T T P : // http://ﬁnance.yahoo.com/ Exchange rate forecasts for the currency of each country. Click on Country Outlook; then click on Exchange Rates to review exchange rate forecasts.

Weakness in some currencies may best be anticipated by a subjective assessment of conditions in a particular country and not by the quantitative methods described here. Thus, MNCs may beneﬁt from using the methods described in this chapter along with their own sense of the conditions in a particular country. Nevertheless, it is still difﬁcult to anticipate that a currency will weaken before a speculative outﬂow occurs. By that time, the currency will have weakened as a result of the outﬂow.

Forecasting Services The corporate need to forecast currency values has prompted the emergence of several forecasting service ﬁ rms, including Business International, Conti Currency, Predex, and Global Insight. In addition, some large investment banks such as Goldman Sachs and commercial banks such as Citigroup offer forecasting services. Many consulting services use at least two different types of analysis to generate separate forecasts and then determine the weighted average of the forecasts. Some forecasting services focus on technical forecasting, while others focus on fundamental forecasting. Forecasts are even provided for currencies that are not widely traded. Forecasting service ﬁ rms provide forecasts on any currency for time horizons of interest to their clients, ranging from one day to 10 years from now. In addition, some ﬁ rms offer advice on international cash management, assessment of exposure to exchange rate risk, and hedging. Many of the ﬁ rms provide their clients with forecasts and recommendations monthly, or even weekly, for an annual fee.

Reliance on Forecasting Services Rather than rely on any forecasting method, an MNC may prefer to rely on a forecasting service. Some studies have compared several forecasting services’ forecasts for different currencies to the forward rate and found that the forecasts provided by ser-

Chapter 9: Forecasting Exchange Rates

263

vices are no better than using the forward rate. Such results are frustrating for the corporations that have paid substantial amounts for expert opinions. Perhaps some corporate clients of these forecasting services believe the fee is justiﬁed even when the forecasting performance is poor, if other services (such as cash management) are included in the package. It is also possible that a corporate treasurer, in recognition of the potential for error in forecasting exchange rates, may prefer to pay a forecasting service ﬁ rm for its forecasts. Then the treasurer is not directly responsible for corporate problems that result from inaccurate currency forecasts. Not all MNCs hire forecasting service ﬁ rms to do their forecasting. For example, Kodak, Inc., once used a service but became dissatisﬁed with it and has now developed its own forecasting system.

Forecast Error Regardless of which method is used or which service is hired to forecast exchange rates, it is important to recognize that forecasted exchange rates are rarely perfect. The potential forecast error is larger for currencies that are more volatile because the spot rates of these currencies could easily wander far from any forecasted value in the future. The potential forecast error also depends on the forecast horizon. A forecast of the spot rate of the euro for tomorrow will have a relatively small error because it probably will not deviate from today’s spot rate by more than 1 percent in one day. However, a forecast of the euro in one month is more difﬁcult because the euro’s value has more time to stray from today’s value. A forecast of one year in advance is even more difﬁcult, and a forecast of 10 years ahead will very likely be subject to large error.

Potential Impact of Forecast Errors When MNCs forecast future exchange rates incorrectly, their ﬁ nancial decisions can backﬁ re. The outcomes of long-term projects in foreign countries are especially vulnerable to exchange rate movements, so that an MNC could invest in a $50 million subsidiary that ultimately fails because it forecasted future exchange rates poorly. Because of the potential for error in forecasting exchange rates, MNCs commonly consider how their potential error may affect their ﬁ nancial decisions before they implement decisions. If Disney considers building a new theme park in Argentina, its final investment decision could be influenced by its forecasts of the Argentine peso value for future years. The forecasts of the Argentine peso’s value in the distant future are subject to large error. Therefore, Disney would probably reassess its investment decision based on many possible exchange rate scenarios before deciding whether the theme park should be established. It may only pursue the project if it was expected to provide a satisfactory return on investment under most of the exchange rate scenarios considered. ■

E X X A M P L E

Measurement of Forecast Error An MNC that forecasts exchange rates must monitor its performance over time to determine whether the forecasting procedure is satisfactory. For this purpose, a measurement of the forecast error is required. There are various ways to compute forecast errors. One popular measurement will be discussed here and is deﬁ ned as follows: 2 Forecasted 2 Realized 2 value value Absolute forecast error as a percentage f 5 of the realized value Realized value

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The error is computed using an absolute value because this avoids a possible offsetting effect when determining the mean forecast error. If the forecast error is .05 in the ﬁ rst period and .05 in the second period (if the absolute value is not taken), the mean error is zero. Yet, that is misleading because the forecast was not perfectly accurate in either period. The absolute value avoids such a distortion. When comparing a forecasting technique’s performance among different currencies, it is often useful to adjust for their relative sizes.

E X A M P L E

Consider the following forecasted and realized values by New Hampshire Co. during one period: Forecasted Value

Realized Value

British pound

$1.35

$1.50

Mexican peso

$ .12

$ .10

In this case, the difference between the forecasted value and the realized value is $.15 for the pound versus $.02 for the peso. This does not necessarily mean that the forecast for the peso is more accurate. When the size of what is forecasted is considered (by dividing the difference by the realized value), one can see that the British pound has been predicted with more accuracy on a percentage basis. With the data given, the forecasting error (as defined earlier) of the British pound is

0 $1.35 2 $1.50 0 $.15 5 5 .10, or 10% $1.50 $1.50 In contrast, the forecast error of the Mexican peso is

0 .12 2 .10 0 .02 5 5 .20, or 20% .10 .10 Thus, the peso has been predicted with less accuracy. ■

Forecast Accuracy over Time MNCs are likely to have more conﬁdence in their measurement of the forecast error when they measure it over each of several periods. The absolute forecast error as a percentage of the realized value can be estimated for each period to derive the mean error over all of these periods. If an MNC is most interested in forecasting the value of a currency 90 days (one quarter) from now, it will assess errors from the application of various forecast procedures over the last several quarters. Have forecasts improved in recent years? The answer depends on the method used to develop forecasts. Exhibit 9.3 shows the magnitude of the absolute errors when the forward rate is used as a predictor for the British pound over time. The size of the errors changes over time. The errors are larger in periods when the pound’s value was more volatile.

Forecast Accuracy among Currencies The ability to forecast currency values may vary with the currency of concern. The Canadian dollar stands out as the currency most accurately predicted. Its mean error is typically less than the mean absolute forecast errors for other major currencies because its value is more stable over time. This information is important because it means that a ﬁ nancial manager of a U.S. ﬁ rm can feel more conﬁdent about the number of dollars to be received (or needed) on Canadian transactions. However, even the

Chapter 9: Forecasting Exchange Rates Exhibit 9.3

265

Absolute Forecast Errors over Time for the British Pound (Using the Forward Rate to Forecast)

$.30

Absolute Forecast Error

$.25

$.20

$.15

$.10

$.05

$.01 1982

1984

1986

1988

1990

1992

1994 1996 Time

1998

2000

2002

2004

2006

2008

Canadian dollar is subject to a large forecast error. It appreciated substantially against the U.S. dollar in the 2004–2007 period, which would have resulted in larger forecast errors when using most forecasting techniques.

Forecast Bias The difference between the forecasted and realized exchange rates for a given point in time is a nominal forecast error. Negative errors over time indicate underestimating, while positive errors indicate overestimating. If the errors are consistently positive or negative over time, then a bias in the forecasting procedure does exist. It appears that a bias did exist in distinct periods. During the strong-pound periods, the forecasts underestimated, while in weak-pound periods, the forecasts overestimated.

Statistical Test of Forecast Bias. If the forward rate is a biased predictor of the future spot rate, this implies that there is a systematic forecast error, which could be corrected to improve forecast accuracy. If the forward rate is unbiased, it fully reﬂects all available information about the future spot rate. In any case, any forecast errors would be the result of events that could not have been antic-

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ipated from existing information at the time of the forecast. A conventional method of testing for a forecast bias is to apply the following regression model to historical data: St 5 a0 1 a1Ft21 1 mt where St spot rate at time t Ft1 forward rate at time t 1 mt error term a 0 intercept a1 regression coefﬁcient If the forward rate is unbiased, the intercept should equal zero, and the regression coefﬁcient a1 should equal 1.0. The t-test for a1 is t5

a1 2 1 Standard error of a1

If a 0 0 and a1 is signiﬁcantly less than 1.0, this implies that the forward rate is systematically overestimating the spot rate. For example, if a 0 0 and a1 .90, the future spot rate is estimated to be 90 percent of the forecast generated by the forward rate. Conversely, if a 0 0 and a1 is signiﬁcantly greater than 1.0, this implies that the forward rate is systematically underestimating the spot rate. For example, if a 0 and a1 1.1, the future spot rate is estimated to be 1.1 times the forecast generated by the forward rate. When a bias is detected and anticipated to persist in the future, future forecasts may incorporate that bias. For example, if a1 1.1, future forecasts of the spot rate may incorporate this information by multiplying the forward rate by 1.1 to create a forecast of the future spot rate. By detecting a bias, an MNC may be able to adjust for the bias so that it can improve its forecasting accuracy. For example, if the errors are consistently positive, an MNC could adjust today’s forward rate downward to reﬂect the bias. Over time, a forecasting bias can change (from underestimating to overestimating, or vice versa). Any adjustment to the forward rate used as a forecast would need to reﬂect the anticipated bias for the period of concern.

Graphic Evaluation of Forecast Performance Forecast performance can be examined with the use of a graph that compares forecasted values with the realized values for various time periods. For eight quarters, Tunek Co. used the 3-month forward rate of Currency Q to forecast Q’s value 3 months ahead. The results from this strategy are shown in Exhibit 9.4, and the predicted and realized exchange rate values in Exhibit 9.4 are compared graphically in Exhibit 9.5. The 45-degree line in Exhibit 9.5 represents perfect forecasts. If the realized value turned out to be exactly what was predicted over several periods, all points would be located on that 45-degree line in Exhibit 9.5. For this reason, the 45-degree line is referred to as the perfect forecast line. The closer the points reflecting the eight periods are vertically to the 45-degree line, the better the forecast. The vertical distance between each point and the 45-degree line is the forecast error. If the point is $.04 above the 45-degree line, this means that the realized spot rate was $.04 higher than the exchange rate forecasted. All points above the 45-degree line reflect underestimation, while all points below the 45-degree line reflect overestimation. ■

E X A M P L E

Chapter 9: Forecasting Exchange Rates

267

Exhibit 9.4 Evaluation of Forecast Performance Period

Predicted Value of Currency Q for End of Period

Realized Value of Currency Q as of End of Period

1

$.20

$.16

2

.18

.14

3

.24

.16

4

.26

.22

5

.30

.28

6

.22

.26

7

.16

.14

8

.14

.10

Exhibit 9.5

Graphic Evaluation of Forecast Performance

Perfect Forecast Line

$.30 $.28 Realized Value (in U.S. Dollars)

5 $.26 $.24 $.22 $.20

6 Region of Downward Bias (above 45-degree line)

$.18 $.16

Region of Upward Bias (below 45-degree line) 3

1

$.14 7

$.12 $.10

4

2

8

$.10 $.12 $.14 $.16 $.18 $.20 $.22 $.24 $.26 $.28 $.30 Predicted Value (in U.S. Dollars)

If points appear to be scattered evenly on both sides of the 45-degree line, then the forecasts are said to be unbiased since they are not consistently above or below the realized values. Whether evaluating the size of forecast errors or attempting to search for a bias, more reliable results are obtained when examining a large number of forecasts. A more thorough assessment of a forecast bias can be conducted by separating the entire period into subperiods as shown in Exhibit 9.6 for the British pound. Each graph reﬂects a particular subperiod. Some graphs show a general underestimation while others show overestimation, which means that the forecast bias changed from one subperiod to another.

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Part 3: Exchange Rate Risk Management

Exhibit 9.6 Graphic Comparison of Forecasted and Realized Spot Rates in Different Subperiods for the British Pound (Using the Forward Rate as the Forecast)

Perfect Forecast Line January 1974–April 1976

July 1976–October 1980

Realized Spot Rate

$2.30

Realized Spot Rate

$2.30

Perfect Forecast Line

$1.15

$1.15

$1.15

$2.30

$1.15

Forward Rate

Perfect Forecast Line

$2.30

Perfect Forecast Line

January 1981–July 1984

October 1984–January 1988

Realized Spot Rate

$2.30

Realized Spot Rate

$2.30

Forward Rate

$1.15

$1.15

$1.15

$2.30

$1.15

Perfect Forecast Line

Perfect Forecast Line $2.30

April 1998–December 2007

Realized Spot Rate

April 1988–July 1998

Realized Spot Rate

$2.30

$2.30 Forward Rate

Forward Rate

$1.15

$1.15

$1.15

$2.30 Forward Rate

$1.15

$2.30 Forward Rate

Chapter 9: Forecasting Exchange Rates

269

Comparison of Forecasting Methods An MNC can compare forecasting methods by plotting the points relating to two methods on a graph similar to Exhibit 9.5. The points pertaining to each method can be distinguished by a particular mark or color. The performance of the two methods can be evaluated by comparing distances of points from the 45-degree line. In some cases, neither forecasting method may stand out as superior when compared graphically. If so, a more precise comparison can be conducted by computing the forecast errors for all periods for each method and then comparing these errors. Xavier Co. uses a fundamental forecasting method to forecast the Polish currency (zloty), which it will need to purchase to buy imports from Poland. Xavier also derives a second forecast for each period based on an alternative forecasting model. Its previous forecasts of the zloty, using Model 1 (the fundamental method) and Model 2 (the alternative method), are shown in columns 2 and 3, respectively, of Exhibit 9.7, along with the realized value of the zloty in column 4. The absolute forecast errors of forecasting with Model 1 and Model 2 are shown in columns 5 and 6, respectively. Notice that Model 1 outperformed Model 2 in six of the eight periods. The mean absolute forecast error when using Model 1 is $.04, meaning that forecasts with Model 1 are off by $.04 on the average. Although Model 1 is not perfectly accurate, it does a better job than Model 2, whose mean absolute forecast error is $.07. Overall, predictions with Model 1 are on the average $.03 closer to the realized value. ■

E X A M P L E

For a complete comparison of performance among forecasting methods, an MNC should evaluate as many periods as possible. Only eight periods are used in our example because that is enough to illustrate how to compare forecasting performance. If the MNC has a large number of periods to evaluate, it could statistically test for signiﬁcant differences in forecasting errors.

Forecasting under Market Efficiency The efﬁciency of the foreign exchange market also has implications for forecasting. If the foreign exchange market is weak-form efﬁcient, then historical and current

Exhibit 9.7

Comparison of Forecast Techniques (3) Predicted Value of Zloty by Model 2

(4)

(5)

(6)

Period

(2) Predicted Value of Zloty by Model 1

Realized Value of Zloty

Absolute Forecast Error Using Model 1

Absolute Forecast Error Using Model 2

(7) (5) (6) Difference in Absolute Forecast Errors (Model 1 Model 2)

1

$.20

$.24

$.16

$.04

$.08

$.04

2

.18

.20

.14

.04

.06

.02

3

.24

.20

.16

.08

.04

.04

4

.26

.20

.22

.04

.02

.02

5

.30

.18

.28

.02

.10

.08

6

.22

.32

.26

.04

.06

.02

7

.16

.20

.14

.02

.06

.04

8

.14

.24

.10

.04

.14

.10

Sum .32 Mean .04

Sum .56 Mean .07

Sum .24 Mean .03

(1)

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exchange rate information is not useful for forecasting exchange rate movements because today’s exchange rates reﬂect all of this information. That is, technical analysis would not be capable of improving forecasts. If the foreign exchange market is semistrong-form efﬁcient, then all relevant public information is already reﬂected in today’s exchange rates. If today’s exchange rates fully reﬂect any historical trends in exchange rate movements, but not other public information on expected interest rate movements, the foreign exchange market is weak-form efﬁcient but not semistrongform efﬁcient. Much research has tested the efﬁcient market hypothesis for foreign exchange markets. Research suggests that foreign exchange markets appear to be weak-form efﬁcient and semistrong-form efﬁcient. However, there is some evidence of inefﬁciencies for some currencies in speciﬁc periods. If foreign exchange markets are strong-form efﬁcient, then all relevant public and private information is already reﬂected in today’s exchange rates. This form of efﬁ ciency cannot be tested because private information is not available. Even though foreign exchange markets are generally found to be at least semistrong-form efﬁcient, forecasts of exchange rates by MNCs may still be worthwhile. Their goal is not necessarily to earn speculative proﬁts but to use reasonable exchange rate forecasts to implement policies. When MNCs assess proposed policies, they usually prefer to develop their own forecasts of exchange rates over time rather than simply use market-based rates as a forecast of future rates. MNCs are often interested in more than a point estimate of an exchange rate 1 year, 3 years, or 5 years from now. They prefer to develop a variety of scenarios and assess how exchange rates may change for each scenario. Even if today’s forward exchange rate properly reﬂects all available information, it does not indicate to the MNC the possible deviation of the realized future exchange rate from what is expected. MNCs need to determine the range of various possible exchange rate movements in order to assess the degree to which their operating performance could be affected. Governance of Managerial Forecasting Managers of an MNC may use forecasts of exchange rates that satisfy their self-centered goals. For example, they may forecast exchange rates that make an international investment that they want to pursue more feasible. This may allow them to expand internationally to increase their responsibility (and compensation). An MNC can prevent the use of such forecasts by imposing controls. It can reassess the feasibility of the international projects based on alternative exchange rate scenarios. Its reassessment may be based on market-based forecasts and forecasts provided by outside consultants. In general, any key managerial decision that is based on forecasted exchange rates should consider other possible outcomes based on alternative exchange rate scenarios. If the feasibility of a proposal by the managers is dependent on the specific exchange rate scenario, the proposal deserves more scrutiny before determining whether it should be approved. ■

GOVE ER RN NA AN NC CE E

Using Interval Forecasts It is nearly impossible to predict future exchange rates with perfect accuracy. For this reason, MNCs may specify an interval around their point estimate forecast. Harp, Inc., based in Oklahoma, imports products from Canada. It uses the spot rate of the Canadian dollar (currently $.70) to forecast the value of the Canadian dollar one month from now. It also specifies an interval around its forecasts, based on the historical volatility of the Canadian dollar. The more volatile the currency, the more likely it is to wander far from the forecasted value in the future (the larger is the expected forecast error). Harp determines that the standard deviation of the Canadian dollar’s movements over the last 12 months is 2 percent. Thus, assuming the movements are normally distributed, it expects that there is

E X A M P L E

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271

a 68 percent chance that the actual value will be within 1 standard deviation (2 percent) of its forecast, which results in an interval from $.686 to $.714. In addition, it expects that there is a 95 percent chance that the Canadian dollar will be within 2 standard deviations (4 percent) of the predicted value, which results in an interval from $.672 to $.728. By specifying an interval, Harp can more properly anticipate how far the actual value of the currency might deviate from its predicted value. If the currency was more volatile, its standard deviation would be larger, and the interval surrounding the point estimate forecast would also be larger. ■

As this example shows, the measurement of a currency’s volatility is useful for specifying an interval around a forecast. However, the volatility of a currency can change over time, which means that past volatility levels will not necessarily be the optimal method of establishing an interval around a point estimate forecast. Therefore, MNCs may prefer to forecast exchange rate volatility to determine the interval surrounding their forecast. The ﬁ rst step in forecasting exchange rate volatility is to determine the relevant period of concern. If an MNC is forecasting the value of the Canadian dollar each day over the next quarter, it may also attempt to forecast the standard deviation of daily exchange rate movements over this quarter. This information could be used along with the point estimate forecast of the Canadian dollar for each day to derive conﬁdence intervals around each forecast.

Methods of Forecasting Exchange Rate Volatility In order to use an interval forecast, the volatility of exchange rate movements can be forecast from (1) recent exchange rate volatility, (2) historical time series of volatilities, and (3) the implied standard deviation derived from currency option prices.

Use of the Recent Volatility Level. The volatility of historical exchange rate movements over a recent period can be used to forecast the future. In our example, the standard deviation of monthly exchange rate movements in the Canadian dollar during the previous 12 months could be used to estimate the future volatility of the Canadian dollar over the next month.

Use of a Historical Pattern of Volatilities. Since historical volatility can change over time, the standard deviation of monthly exchange rate movements in the last 12 months is not necessarily an accurate predictor of the volatility of exchange rate movements in the next month. To the extent that there is a pattern to the changes in exchange rate volatility over time, a series of time periods may be used to forecast volatility in the next period. The standard deviation of monthly exchange rate movements in the Canadian dollar can be determined for each of the last several years. Then, a time-series trend of these standard deviation levels can be used to form an estimate for the volatility of the Canadian dollar over the next month. The forecast may be based on a weighting scheme such as 60 percent times the standard deviation in the last year, plus 30 percent times the standard deviation in the year before that, plus 10 percent times the standard deviation in the year before that. This scheme places more weight on the most recent data to derive the forecast but allows data from the last 3 years to influence the forecast. Normally, the weights that achieved the most accuracy (lowest forecast error) over previous periods would be used when applying this method to forecast exchange rate volatility. ■

E X X A M P L E

Various economic and political factors can cause exchange rate volatility to change abruptly, however, so even sophisticated time-series models do not necessarily generate

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accurate forecasts of exchange rate volatility. A poor forecast of exchange rate volatility can lead to an improper interval surrounding a point estimate forecast.

H T T P : // http://www.fednewyork.org/ markets/impliedvolatility .html Implied volatilities of major currencies. The implied volatility can be used to measure the market’s expectations of a speciﬁc currency’s volatility in the future.

Implied Standard Deviation. A third method for forecasting exchange rate volatility is to derive the exchange rate’s implied standard deviation (ISD) from the currency option pricing model. Recall that the premium on a call option for a currency is dependent on factors such as the relationship between the spot exchange rate and the exercise (strike) price of the option, the number of days until the expiration date of the option, and the anticipated volatility of the currency’s exchange rate movements. There is a currency option pricing model for estimating the call option premium based on various factors. The actual values of each of these factors are known, except for the anticipated volatility. By plugging in the prevailing option premium paid by investors for that speciﬁc currency option, however, it is possible to derive the market’s anticipated volatility for that currency. The volatility is measured by the standard deviation, which can be used to develop a probability distribution surrounding the forecast of the currency’s exchange rate.

SUMMARY ■ Multinational corporations need exchange rate forecasts to make decisions on hedging payables and receivables, short-term ﬁ nancing and investment, capital budgeting, and long-term ﬁ nancing. ■ The most common forecasting techniques can be classiﬁed as (1) technical, (2) fundamental, (3) market based, and (4) mixed. Each technique has limitations, and the quality of the forecasts produced varies. Yet, due to the high variability in exchange rates, it should not be surprising that forecasts are not always accurate.

POINT

■ Forecasting methods can be evaluated by comparing the actual values of currencies to the values predicted by the forecasting method. To be meaningful, this comparison should be conducted over several periods. Two criteria used to evaluate performance of a forecast method are bias and accuracy. When comparing the accuracy of forecasts for two currencies, the absolute forecast error should be divided by the realized value of the currency to control for differences in the relative values of currencies.

COUNTER-POINT

Which Exchange Rate Forecast Technique Should MNCs Use? Point Use the spot rate to forecast. When a U.S.based MNC ﬁ rm conducts ﬁ nancial budgeting, it must estimate the values of its foreign currency cash ﬂows that will be received by the parent. Since it is well documented that ﬁ rms cannot accurately forecast future values, MNCs should use the spot rate for budgeting. Changes in economic conditions are difﬁcult to predict, and the spot rate reﬂects the best guess of the future spot rate if there are no changes in economic conditions. Counter-Point Use the forward rate to forecast. The spot rates of some currencies do not represent accurate or even unbiased estimates of the future

spot rates. Many currencies of developing countries have generally declined over time. These currencies tend to be in countries that have high inﬂation rates. If the spot rate had been used for budgeting, the dollar cash ﬂows resulting from cash inﬂows in these currencies would have been highly overestimated. The expected inﬂation in a country can be accounted for by using the nominal interest rate. A high nominal interest rate implies a high level of expected inﬂation. Based on interest rate parity, these currencies will have pronounced discounts. Thus, the forward rate captures the expected inﬂation differential between countries

Chapter 9: Forecasting Exchange Rates

because it is inﬂuenced by the nominal interest rate differential. Since it captures the inﬂation differential, it should provide a more accurate forecast of currencies, especially those currencies in high-inﬂation countries.

SELF

Who Is Correct? Use the Internet to learn more about this issue. Which argument do you support? Offer your own opinion on this issue.

TEST

Answers are provided in Appendix A at the back of the text. 1. Assume that the annual U.S. return is expected to be 7 percent for each of the next 4 years, while the annual interest rate in Mexico is expected to be 20 percent. Determine the appropriate 4-year forward rate premium or discount on the Mexican peso, which could be used to forecast the percentage change in the peso over the next 4 years. 2. Consider the following information:

90-Day Forward Rate

Spot Rate That Occurred 90 Days Later

Canadian dollar

$.80

$.82

Japanese yen

$.012

$.011

Currency

273

3. Assume that the forward rate and spot rate of the Mexican peso are normally similar at a given point in time. Assume that the peso has depreciated con-

AND

4. An analyst has stated that the British pound seems to increase in value over the 2 weeks following announcements by the Bank of England (the British central bank) that it will raise interest rates. If this statement is true, what are the inferences regarding weak-form or semistrong-form efﬁciency? 5. Assume that Mexican interest rates are much higher than U.S. interest rates. Also assume that interest rate parity (discussed in Chapter 7) exists. If you use the forward rate of the Mexican peso to forecast the Mexican peso’s future spot rate, would you expect the peso to appreciate or depreciate? Explain.

Assuming the forward rate was used to forecast the future spot rate, determine whether the Canadian dollar or the Japanese yen was forecasted with more accuracy, based on the absolute forecast error as a percentage of the realized value.

QUESTIONS

sistently and substantially over the last 3 years. Would the forward rate have been biased over this period? If so, would it typically have overestimated or underestimated the future spot rate of the peso (in dollars)? Explain.

6. Warden Co. is considering a project in Venezuela, which will be very proﬁtable if the local currency (bolivar) appreciates against the dollar. If the bolivar depreciates, the project will result in losses. Warden Co. forecasts that the bolivar will appreciate. The bolivar’s value historically has been very volatile. As a manager of Warden Co., would you be comfortable with this project? Explain.

A P P L I CAT I O N S

1. Motives for Forecasting. Explain corporate motives for forecasting exchange rates. 2. Technical Forecasting. Explain the technical technique for forecasting exchange rates. What are some limitations of using technical forecasting to predict exchange rates?

What is the rationale for using market-based forecasts? If the euro appreciates substantially against the dollar during a speciﬁc period, would marketbased forecasts have overestimated or underestimated the realized values over this period? Explain. 5. Mixed Forecasting. Explain the mixed technique for forecasting exchange rates.

3. Fundamental Forecasting. Explain the fundamental technique for forecasting exchange rates. What are some limitations of using a fundamental technique to forecast exchange rates?

6. Detecting a Forecast Bias. Explain how to assess performance in forecasting exchange rates. Explain how to detect a bias in forecasting exchange rates.

4. Market-Based Forecasting. Explain the marketbased technique for forecasting exchange rates.

7. Measuring Forecast Accuracy. You are hired as a consultant to assess a ﬁ rm’s ability to forecast. The

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ﬁ rm has developed a point forecast for two different currencies presented in the following table. The ﬁ rm asks you to determine which currency was forecasted with greater accuracy.

Period

Yen Forecast

Actual Yen Value

Pound Forecast

Actual Pound Value

1

$.0050

$.0051

$1.50

$1.51

2

.0048

.0052

1.53

1.50

3

.0053

.0052

1.55

1.58

4

.0055

.0056

1.49

1.52

8. Limitations of a Fundamental Forecast. Syracuse Corp. believes that future real interest rate movements will affect exchange rates, and it has applied regression analysis to historical data to assess the relationship. It will use regression coefﬁcients derived from this analysis, along with forecasted real interest rate movements, to predict exchange rates in the future. Explain at least three limitations of this method. 9. Consistent Forecasts. Lexington Co. is a U.S.based MNC with subsidiaries in most major countries. Each subsidiary is responsible for forecasting the future exchange rate of its local currency relative to the U.S. dollar. Comment on this policy. How might Lexington Co. ensure consistent forecasts among the different subsidiaries? 10. Forecasting with a Forward Rate. Assume that the 4-year annualized interest rate in the United States is 9 percent and the 4-year annualized interest rate in Singapore is 6 percent. Assume interest rate parity holds for a 4-year horizon. Assume that the spot rate of the Singapore dollar is $.60. If the forward rate is used to forecast exchange rates, what will be the forecast for the Singapore dollar’s spot rate in 4 years? What percentage appreciation or depreciation does this forecast imply over the 4-year period?

derive a point estimate of a future exchange rate but to assess how wrong our estimate might be.” What does this statement mean? 13. Forecasting Exchange Rates of Currencies That Previously Were Fixed. When some countries in Eastern Europe initially allowed their currencies to ﬂuctuate against the dollar, would the fundamental technique based on historical relationships have been useful for forecasting future exchange rates of these currencies? Explain. 14. Forecast Error. Royce Co. is a U.S. ﬁ rm with future receivables one year from now in Canadian dollars and British pounds. Its pound receivables are known with certainty, and its estimated Canadian dollar receivables are subject to a 2 percent error in either direction. The dollar values of both types of receivables are similar. There is no chance of default by the customers involved. Royce’s treasurer says that the estimate of dollar cash ﬂows to be generated from the British pound receivables is subject to greater uncertainty than that of the Canadian dollar receivables. Explain the rationale for the treasurer’s statement. 15. Forecasting the Euro. Cooper, Inc., a U.S.-based MNC, periodically obtains euros to purchase German products. It assesses U.S. and German trade patterns and inﬂation rates to develop a fundamental forecast for the euro. How could Cooper possibly improve its method of fundamental forecasting as applied to the euro? 16. Forward Rate Forecast. Assume that you obtain a quote for a one-year forward rate on the Mexican peso. Assume that Mexico’s one-year interest rate is 40 percent, while the U.S. one-year interest rate is 7 percent. Over the next year, the peso depreciates by 12 percent. Do you think the forward rate overestimated the spot rate one year ahead in this case? Explain.

11. Foreign Exchange Market Efﬁciency. Assume that foreign exchange markets were found to be weakform efﬁcient. What does this suggest about utilizing technical analysis to speculate in euros? If MNCs believe that foreign exchange markets are strong-form efﬁcient, why would they develop their own forecasts of future exchange rates? That is, why wouldn’t they simply use today’s quoted rates as indicators about future rates? After all, today’s quoted rates should reﬂect all relevant information.

17. Forecasting Based on PPP versus the Forward Rate. You believe that the Singapore dollar’s exchange rate movements are mostly attributed to purchasing power parity. Today, the nominal annual interest rate in Singapore is 18 percent. The nominal annual interest rate in the United States is 3 percent. You expect that annual inﬂation will be about 4 percent in Singapore and 1 percent in the United States. Assume that interest rate parity holds. Today the spot rate of the Singapore dollar is $.63. Do you think the one-year forward rate would underestimate, overestimate, or be an unbiased estimate of the future spot rate in one year? Explain.

12. Forecast Error. The director of currency forecasting at Champaign-Urbana Corp. says, “The most critical task of forecasting exchange rates is not to

18. Interpreting an Unbiased Forward Rate. Assume that the forward rate is an unbiased but not necessarily accurate forecast of the future exchange rate

Chapter 9: Forecasting Exchange Rates

of the yen over the next several years. Based on this information, do you think Raven Co. should hedge its remittance of expected Japanese yen proﬁts to the U.S. parent by selling yen forward contracts? Why would this strategy be advantageous? Under what conditions would this strategy backﬁ re? Advanced Questions 19. Probability Distribution of Forecasts. Assume that the following regression model was applied to historical quarterly data: et a 0 a1INT t a2INFt1 mt where et percentage change in the exchange rate of the Japanese yen in period t INTt average real interest rate differential (U.S. interest rate minus Japanese interest rate) over period t INFt1 inﬂation differential (U.S. inﬂation rate minus Japanese inﬂation rate) in the previous period a 0, a1, a2 regression coefﬁcients mt error term Assume that the regression coefﬁcients were estimated as follows:

a 0 .0 a1 .9 a2 .8

275

S a 0 a1(F) The regression results are as follows: Coefﬁcient

Standard Error

a0 .006

.011

a1 .800

.05

Based on these results, is there a bias in the forecast? Verify your conclusion. If there is a bias, explain whether it is an overestimate or an underestimate. 21. Effect of September 11 on Forward Rate Forecasts. The September 11, 2001, terrorist attack on the United States was quickly followed by lower interest rates in the United States. How would this affect a fundamental forecast of foreign currencies? How would this affect the forward rate forecast of foreign currencies? 22. Interpreting Forecast Bias Information. The treasurer of Glencoe, Inc., detected a forecast bias when using the 30-day forward rate of the euro to forecast future spot rates of the euro over various periods. He believes he can use this information to determine whether imports ordered every week should be hedged (payment is made 30 days after each order). Glencoe’s president says that in the long run the forward rate is unbiased and that the treasurer should not waste time trying to “beat the forward rate” but should just hedge all orders. Who is correct?

Interest Rate Differential

Probability

0%

30%

1

60

23. Forecasting Latin American Currencies. The value of each Latin American currency relative to the dollar is dictated by supply and demand conditions between that currency and the dollar. The values of Latin American currencies have generally declined substantially against the dollar over time. Most of these countries have high inﬂation rates and high interest rates. The data on inﬂation rates, economic growth, and other economic indicators are subject to error, as limited resources are used to compile the data.

2

10

a. If the forward rate is used as a market-based fore-

Also assume that the inﬂation differential in the most recent period was 3 percent. The real interest rate differential in the upcoming period is forecasted as follows:

If Stillwater, Inc., uses this information to forecast the Japanese yen’s exchange rate, what will be the probability distribution of the yen’s percentage change over the upcoming period? 20. Testing for a Forecast Bias. You must determine whether there is a forecast bias in the forward rate. You apply regression analysis to test the relationship between the actual spot rate and the forward rate forecast (F):

cast, will this rate result in a forecast of appreciation, depreciation, or no change in any particular Latin American currency? Explain. b. If technical forecasting is used, will this result

in a forecast of appreciation, depreciation, or no change in the value of a speciﬁc Latin American currency? Explain. c. Do you think that U.S. ﬁ rms can accurately fore-

cast the future values of Latin American currencies? Explain.

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24. Selecting between Forecast Methods. Bolivia currently has a nominal one-year risk-free interest rate of 40 percent, which is primarily due to the high level of expected inﬂation. The U.S. nominal oneyear risk-free interest rate is 8 percent. The spot rate of Bolivia’s currency (called the boliviana) is $.14. The one-year forward rate of the boliviana is $.108. What is the forecasted percentage change in the boliviana if the spot rate is used as a one-year forecast? What is the forecasted percentage change in the boliviana if the one-year forward rate is used as a oneyear forecast? Which forecast do you think will be more accurate? Why? 25. Comparing Market-based Forecasts. For all parts of this question, assume that interest rate parity exists, the prevailing one-year U.S. nominal interest rate is low, and that you expect U.S. inﬂation to be low this year. a. Assume that the country Dinland engages

in much trade with the United States and the trade involves many different products. Dinland has had a zero trade balance with the United States (the value of exports and imports is about the same) in the past. Assume that you expect a high level of inﬂation (about 40 percent) in Dinland over the next year because of a large increase in the prices of many products that Dinland produces. Dinland presently has a one-year risk-free interest rate of more than 40 percent. Do you think that the prevailing spot rate or the one-year forward rate would result in a more accurate forecast of Dinland’s currency (the din) one year from now? Explain. b. Assume that the country Freeland engages in

much trade with the United States and the trade involves many different products. Freeland has had a zero trade balance with the United States (the value of exports and imports is about the same) in the past. You expect high inﬂation (about 40 percent) in Freeland over the next year because of a large increase in the cost of land (and therefore housing) in Freeland. You believe that the prices of products that Freeland produces will not be affected. Freeland presently has a one-year risk-free interest rate of more than 40 percent. Do you think that the prevailing one-year forward rate of Freeland’s currency (the fre) would overestimate, underestimate, or be a reasonably accurate forecast of the spot rate one year from now? (Presume a direct quotation of the exchange rate, so that if the forward rate underestimates, it means that its value is less than the realized spot rate in one year. If the forward rate overestimates, it means that its value is more than the realized spot rate in one year.)

26. IRP and Forecasting. New York Co. has agreed to pay 10 million Australian dollars (A$) in 2 years for equipment that it is importing from Australia. The spot rate of the Australian dollar is $.60. The annualized U.S. interest rate is 4 percent, regardless of the debt maturity. The annualized Australian dollar interest rate is 12 percent regardless of the debt maturity. New York plans to hedge its exposure with a forward contract that it will arrange today. Assume that interest rate parity exists. Determine the amount of U.S. dollars that New York Co. will need in 2 years to make its payment. 27. Forecasting Based on the International Fisher Effect. Purdue Co. (based in the United States) exports cable wire to Australian manufacturers. It invoices its product in U.S. dollars and will not change its price over the next year. There is intense competition between Purdue and the local cable wire producers based in Australia. Purdue’s competitors invoice their products in Australian dollars and will not be changing their prices over the next year. The annualized risk-free interest rate is presently 8 percent in the United States, versus 3 percent in Australia. Today the spot rate of the Australian dollar is $.55. Purdue Co. uses this spot rate as a forecast of the future exchange rate of the Australian dollar. Purdue expects that revenue from its cable wire exports to Australia will be about $2 million over the next year. If Purdue decides to use the international Fisher effect rather than the spot rate to forecast the exchange rate of the Australian dollar over the next year, will its expected revenue from its exports be higher, lower, or unaffected? Explain. 28. IRP, Expectations, and Forecast Error. Assume that interest rate parity exists and it will continue to exist in the future. Assume that interest rates of the United States and the United Kingdom vary substantially in many periods. You expect that interest rates at the beginning of each month have a major effect on the British pound’s exchange rate at the end of each month because you believe that capital ﬂows between the United States and the United Kingdom inﬂuence the pound’s exchange rate. You expect that money will ﬂow to whichever country has the higher nominal interest rate. At the beginning of each month, you will either use the spot rate or the one-month forward rate to forecast the future spot rate of the pound that will exist at the end of the month. Will the use of the spot rate as a forecast result in smaller, larger, or the same mean absolute forecast error as the forward rate when forecasting the future spot rate of the pound on a monthly basis? Explain.

Chapter 9: Forecasting Exchange Rates

Discussion in the Boardroom

Running Your Own MNC

This exercise can be found in Appendix E at the back of this textbook.

This exercise can be found on the Xtra! website at http://maduraxtra.swlearning.com.

BLADES,

INC.

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CASE

Forecasting Exchange Rates Recall that Blades, Inc., the U.S.-based manufacturer of roller blades, is currently both exporting to and importing from Thailand. Ben Holt, Blades’ chief ﬁ nancial ofﬁcer (CFO), and you, a ﬁ nancial analyst at Blades, Inc., are reasonably happy with Blades’ current performance in Thailand. Entertainment Products, Inc., a Thai retailer for sporting goods, has committed itself to purchase a minimum number of Blades’ “Speedos” annually. The agreement will terminate after 3 years. Blades also imports certain components needed to manufacture its products from Thailand. Both Blades’ imports and exports are denominated in Thai baht. Because of these arrangements, Blades generates approximately 10 percent of its revenue and 4 percent of its cost of goods sold in Thailand. Currently, Blades’ only business in Thailand consists of this export and import trade. Ben Holt, however, is thinking about using Thailand to augment Blades’ U.S. business in other ways as well in the future. For example, Holt is contemplating establishing a subsidiary in Thailand to increase the percentage of Blades’ sales to that country. Furthermore, by establishing a subsidiary in Thailand, Blades will have access to Thailand’s money and capital markets. For instance, Blades could instruct its Thai subsidiary to invest excess funds or to satisfy its short-term needs for funds in the Thai money market. Furthermore, part of the subsidiary’s ﬁ nancing could be obtained by utilizing investment banks in Thailand. Due to Blades’ current arrangements and future plans, Ben Holt is concerned about recent developments in Thailand and their potential impact on the company’s future in that country. Economic conditions in Thailand have been unfavorable recently. Movements in the value of the baht have been highly volatile, and foreign investors in Thailand have lost conﬁdence in the baht, causing massive capital outﬂows from Thailand. Consequently, the baht has been depreciating. When Thailand was experiencing a high economic growth rate, few analysts anticipated an economic downturn. Consequently, Holt never found it necessary to forecast economic conditions in Thailand even though Blades was doing business there. Now, however, his attitude has changed. A continuation of the

unfavorable economic conditions prevailing in Thailand could affect the demand for Blades’ products in that country. Consequently, Entertainment Products may not renew its commitment for another 3 years. Since Blades generates net cash inﬂows denominated in baht, a continued depreciation of the baht could adversely affect Blades, as these net inﬂows would be converted into fewer dollars. Thus, Blades is also considering hedging its baht-denominated inﬂows. Because of these concerns, Holt has decided to reassess the importance of forecasting the baht-dollar exchange rate. His primary objective is to forecast the baht-dollar exchange rate for the next quarter. A secondary objective is to determine which forecasting technique is the most accurate and should be used in future periods. To accomplish this, he has asked you, a ﬁ nancial analyst at Blades, for help in forecasting the baht-dollar exchange rate for the next quarter. Holt is aware of the forecasting techniques available. He has collected some economic data and conducted a preliminary analysis for you to use in your analysis. For example, he has conducted a time-series analysis for the exchange rates over numerous quarters. He then used this analysis to forecast the baht’s value next quarter. The technical forecast indicates a depreciation of the baht by 6 percent over the next quarter from the baht’s current level of $.023 to $.02162. He has also conducted a fundamental forecast of the baht-dollar exchange rate using historical inﬂation and interest rate data. The fundamental forecast, however, depends on what happens to Thai interest rates during the next quarter and therefore reﬂects a probability distribution. Based on the inﬂation and interest rates, there is a 30 percent chance that the baht will depreciate by 2 percent, a 15 percent chance that the baht will depreciate by 5 percent, and a 55 percent chance that the baht will depreciate by 10 percent. Ben Holt has asked you to answer the following questions: 1. Considering both Blades’ current practices and future plans, how can it beneﬁt from forecasting the baht-dollar exchange rate?

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Part 3: Exchange Rate Risk Management

2. Which forecasting technique (i.e., technical, fundamental, or market-based) would be easiest to use in forecasting the future value of the baht? Why? 3. Blades is considering using either current spot rates or available forward rates to forecast the future value of the baht. Available forward rates currently exhibit a large discount. Do you think the spot or the forward rate will yield a better market-based forecast? Why? 4. The current 90-day forward rate for the baht is $.021. By what percentage is the baht expected to change over the next quarter according to a marketbased forecast using the forward rate? What will be the value of the baht in 90 days according to this forecast? 5. Assume that the technical forecast has been more accurate than the market-based forecast in recent

SMALL

BUSINESS

weeks. What does this indicate about market efﬁciency for the baht-dollar exchange rate? Do you think this means that technical analysis will always be superior to other forecasting techniques in the future? Why or why not? 6. What is the expected value of the percentage change in the value of the baht during the next quarter based on the fundamental forecast? What is the forecasted value of the baht using the expected value as the forecast? If the value of the baht 90 days from now turns out to be $.022, which forecasting technique is the most accurate? (Use the absolute forecast error as a percentage of the realized value to answer the last part of this question.) 7. Do you think the technique you have identiﬁed in question 6 will always be the most accurate? Why or why not?

DILEMMA

Exchange Rate Forecasting by the Sports Exports Company The Sports Exports Company converts British pounds into dollars every month. The prevailing spot rate is about $1.65, but there is much uncertainty about the future value of the pound. Jim Logan, owner of the Sports Exports Company, expects that British inﬂation will rise substantially in the future. In previous years when British inﬂation was high, the pound depreciated. The prevailing British interest rate is slightly higher than the prevailing U.S. interest rate. The pound has risen slightly over each of the last several months. Jim wants to forecast the value of the pound for each of the next 20 months. 1. Explain how Jim can use technical forecasting to forecast the future value of the pound. Based on the information provided, do you think that a technical forecast will predict future appreciation or depreciation in the pound?

I N T E R N E T/ E XC E L The website of the Chicago Mercantile Exchange (CME) provides information about the exchange and the futures contracts offered on the exchange. Its address is http://www.cme.com.

2. Explain how Jim can use fundamental forecasting to forecast the future value of the pound. Based on the information provided, do you think that a fundamental forecast will predict appreciation or depreciation in the pound? 3. Explain how Jim can use a market-based forecast to forecast the future value of the pound. Do you think the market-based forecast will predict appreciation, depreciation, or no change in the value of the pound? 4. Does it appear that all of the forecasting techniques will lead to the same forecast of the pound’s future value? Which technique would you prefer to use in this situation?

EXERCISES 1. Use the CME website to review the historical quotes of futures contracts and obtain a recent quote for the Japanese yen and British pound contracts. Then go to http://www.oanda.com/convert/

Chapter 9: Forecasting Exchange Rates fxhistory. Obtain the spot exchange rate for the Japanese yen and British pound on the same date that you have futures contract quotations. Does the Japanese yen futures price reﬂect a premium or a discount relative to its spot rate? Does the futures price imply appreciation or depreciation of the Japanese yen? Repeat these two questions for the British pound.

2. Go to http://www.oanda.com/convert/fxhistory and obtain the direct exchange rate of the Canadian dollar at the beginning of each of the last 7 years. Insert this information in a column on an

279

electronic spreadsheet. (See Appendix C for help on conducting analyses with Excel.) Repeat the process to obtain the direct exchange rate of the euro. Assume that you use the spot rate to forecast the future spot rate one year ahead. Determine the forecast error (measured as the absolute forecast error as a percentage of the realized value for each year) for the Canadian dollar in each year. Then determine the mean of the annual forecast error over all years. Repeat this process for the euro. Which currency has a lower forecast error on average? Would you have expected this result? Explain.

10: Measuring Exposure to Exchange Rate Fluctuations Exchange rate risk can be broadly deﬁned as the risk that a company’s performance will be affected by exchange rate movements. Multinational corporations (MNCs) closely monitor their operations to determine how they are exposed to various forms of exchange rate risk. Financial managers must understand how to measure the exposure of their MNCs to exchange rate ﬂuctuations so that they can determine whether and how to protect their companies from that exposure.

The speciﬁc objectives of this chapter are to: ■ discuss the relevance of an MNC’s exposure to ex-

change rate risk, ■ explain how transaction exposure can be measured, ■ explain how economic exposure can be measured,

and ■ explain how translation exposure can be measured.

Is Exchange Rate Risk Relevant? Some have argued that exchange rate risk is irrelevant. These contentions, in turn, have resulted in counterarguments, as summarized here.

Purchasing Power Parity Argument One argument for exchange rate irrelevance is that, according to purchasing power parity (PPP) theory, exchange rate movements are just a response to differentials in price changes between countries. Therefore, the exchange rate effect is offset by the change in prices. Franklin Co. is a U.S. exporter that denominates its exports in euros. If the euro weakens by 3 percent due to purchasing power parity, that implies that European inﬂation is about 3 percent higher than U.S. inﬂation. If European competitors raise their prices in line with European inﬂation, Franklin can increase its prices without losing any customers. Thus, the increase in its price offsets the reduction in the value of the euro. ■

E E X X A A M M P P L L E E

PPP does not necessarily hold, however, so the exchange rate will not necessarily change in accordance with the inﬂation differential between the two countries. Since a perfect offsetting effect is unlikely, the ﬁrm’s competitive capabilities may indeed be inﬂuenced by exchange rate movements. Even if PPP did hold over a very long period of time, this would not comfort managers of MNCs that are focusing on the next quarter or year.

The Investor Hedge Argument A second argument for exchange rate irrelevance is that investors in MNCs can hedge exchange rate risk on their own. The investor hedge argument assumes that investors have complete information on corporate exposure to exchange rate ﬂuctuations

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Chapter 10: Measuring Exposure to Exchange Rate Fluctuations

281

as well as the capabilities to correctly insulate their individual exposure. To the extent that investors prefer that corporations perform the hedging for them, exchange rate exposure is relevant to corporations. An MNC may be able to hedge at a lower cost than individual investors. In addition, it has more information about its exposure and can more effectively hedge its exposure.

Currency Diversiﬁcation Argument Another argument is that if a U.S.-based MNC is well diversiﬁed across numerous countries, its value will not be affected by exchange rate movements because of offsetting effects. It is naive, however, to presume that exchange rate effects will offset each other just because an MNC has transactions in many different currencies.

Stakeholder Diversiﬁcation Argument Some critics also argue that if stakeholders (such as creditors or stockholders) are well diversiﬁed, they will be somewhat insulated against losses experienced by an MNC due to exchange rate risk. Many MNCs are similarly affected by exchange rate movements, however, so it is difﬁcult to compose a diversiﬁed portfolio of stocks that will be insulated from exchange rate movements.

Response from MNCs Creditors that provide loans to MNCs can experience large losses if the MNCs experience ﬁnancial problems. Thus, creditors may prefer that the MNCs maintain low exposure to exchange rate risk. Consequently, MNCs that hedge their exposure to risk may be able to borrow funds at a lower cost. To the extent that MNCs can stabilize their earnings over time by hedging their exchange rate risk, they may also reduce their general operating expenses over time (by avoiding costs of downsizing and restructuring). Many MNCs, including Colgate-Palmolive, Eastman Kodak, and Merck, have attempted to stabilize their earnings with hedging strategies because they believe exchange rate risk is relevant. Further evidence that MNCs consider exchange rate risk to be relevant can be found in annual reports. The following comments from annual reports of MNCs are typical: The primary purpose of the Company’s foreign currency hedging program is to manage the volatility associated with foreign currency purchases of materials and other assets and liabilities created in the normal course of business. Corporate policy prescribes a range of allowable hedging activity. Procter & Gamble Co. The Company enters into foreign exchange contracts and options to hedge various currency exposures. . . . the primary business objective of the activity is to optimize the U.S. dollar value of the Company’s assets, liabilities, and future cash flows with respect to exchange rate fluctuations. Dow Chemical Co.

Types of Exposure As mentioned in the previous chapter, exchange rates cannot be forecasted with perfect accuracy, but the ﬁrm can at least measure its exposure to exchange rate ﬂuctuations. If the ﬁrm is highly exposed to exchange rate ﬂuctuations, it can consider techniques to reduce its exposure. Such techniques are identiﬁed in the following chapter. Before choosing among them, the ﬁrm should ﬁrst measure its degree of exposure.

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Exposure to exchange rate ﬂuctuations comes in three forms: • Transaction exposure • Economic exposure • Translation exposure Each type of exposure will be discussed in turn.

Transaction Exposure The value of a ﬁ rm’s future contractual transactions in foreign currencies is affected by exchange rate movements. The sensitivity of the ﬁ rm’s contractual transactions in foreign currencies to exchange rate movements is referred to as transaction exposure. Transaction exposure can have a substantial impact on a ﬁrm’s value. It is not unusual for a currency to change by as much as 10 percent in a given year. If an exporter denominates its exports in a foreign currency, a 10 percent decline in that currency will reduce the dollar value of its receivables by 10 percent. This effect could possibly eliminate any proﬁts from exporting. To assess transaction exposure, an MNC needs to (1) estimate its net cash ﬂows in each currency and (2) measure the potential impact of the currency exposure.

Estimating “Net” Cash Flows in Each Currency MNCs tend to focus on transaction exposure over an upcoming short-term period (such as the next month or the next quarter) for which they can anticipate foreign currency cash ﬂows with reasonable accuracy. Since MNCs commonly have foreign subsidiaries spread around the world, they need an information system that can track their currency positions. The Internet enables all subsidiaries to tap into the same network and provide information on their existing and expected future currency positions. To measure its transaction exposure, an MNC needs to project the consolidated net amount in currency inﬂows or outﬂows for all its subsidiaries, categorized by currency. One foreign subsidiary may have inﬂows of a foreign currency while another has outﬂows of that same currency. In that case, the MNC’s net cash ﬂows of that currency overall may be negligible. If most of the MNC’s subsidiaries have future inﬂows in another currency, however, the net cash ﬂows in that currency could be substantial. Estimating the consolidated net cash ﬂows per currency is a useful ﬁrst step when assessing an MNC’s exposure because it helps to determine the MNC’s overall position in each currency. Miami Co. conducts its international business in four currencies. Its objective is to ﬁrst measure its exposure in each currency in the next quarter and then estimate its consolidated cash ﬂows for one quarter ahead, as shown in Exhibit 10.1. For example, Miami expects Canadian dollar inﬂows of C$12 million and outﬂows of C$2 million over the next quarter. Thus, Miami expects net inﬂows of C$10 million. Given an expected exchange rate of $.80 at the end of the quarter, it can convert the expected net inﬂow of Canadian dollars into an expected net inﬂow of $8 million (estimated as C$10 million $.80). The same process is used to determine the net cash ﬂows of each of the other three currencies. Notice from the last column of Exhibit 10.1 that the expected net cash ﬂows in three of the currencies are positive, while the net cash ﬂows in Swedish kronor are negative (reﬂecting cash outﬂows). Thus, Miami will be favorably affected by appreciation of the pound, Canadian dollar, and Mexican peso. Conversely, it will be adversely affected by appreciation of the krona.

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Chapter 10: Measuring Exposure to Exchange Rate Fluctuations

283

The information in Exhibit 10.1 needs to be converted into dollars so that Miami Co. can assess the exposure of each currency by using a standardized measure. For each currency, the net cash ﬂows are converted into dollars to determine the dollar amount of exposure. Notice that Miami has a smaller dollar amount of exposure in Mexican pesos and Canadian dollars than in the other currencies. However, this does not necessarily mean that Miami will be less affected by these exposures, as will be explained shortly. Recognize that the net inﬂows or outﬂows in each foreign currency and the exchange rates at the end of the period are uncertain. Thus, Miami might develop a range of possible exchange rates for each currency, as shown in Exhibit 10.2, instead of a point estimate. In this case, there is a range of net cash ﬂows in dollars rather than a point estimate. Notice that the range of dollar cash ﬂows resulting from Miami’s peso transactions is wide, reﬂecting the high degree of uncertainty surrounding the peso’s value over the next quarter. In contrast, the range of dollar cash ﬂows resulting from the Canadian dollar transactions is narrow because the Canadian dollar is expected to be relatively stable over the next quarter. ■

Miami Co. assessed its net cash ﬂow situation for only one quarter. It could also derive its expected net cash ﬂows for other periods, such as a week or a month. Some MNCs assess their transaction exposure during several periods by applying the methods just described to each period. The further into the future an MNC attempts to measure its transaction exposure, the less accurate will be the measurement due to the greater uncertainty about inﬂows or outﬂows in each foreign currency, as well as future exchange rates, over periods further into the future. An MNC’s overall exposure can be assessed only after considering each currency’s variability and the correlations among currencies. The overall exposure of Miami Co. will be assessed after the following discussion of currency variability and correlations.

Exhibit 10.1

Consolidated Net Cash Flow Assessment of Miami Co.

Net Inﬂow or Outﬂow

Expected Exchange Rate at End of Quarter

Net Inﬂow or Outﬂow as Measured in U.S. Dollars

Currency

Total Inﬂow

Total Outﬂow

British pound

£17,000,000

£7,000,000

£10,000,000

$1.50

$15,000,000

Canadian dollar

C$12,000,000

C$2,000,000

C$10,000,000

$.80

$ 8,000,000

Swedish krona

SK20,000,000

SK120,000,000

SK100,000,000

$.15

$15,000,000

MXP90,000,000

MXP10,000,000

MXP80,000,000

$.10

$ 8,000,000

Mexican peso

Exhibit 10.2

Estimating the Range of Net Inﬂows or Outﬂows for Miami Co. Range of Possible Net Inﬂows or Outﬂows in U.S. Dollars (Based on Range of Possible Exchange Rates)

Currency

Net Inﬂow or Outﬂow

Range of Possible Exchange Rates at End of Quarter

British pound

£10,000,000

$1.40 to $1.60

$14,000,000 to $16,000,000

Canadian dollar

C$10,000,000

$.79 to $.81

$ 7,900,000 to $ 8,100,000

Swedish krona

SK100,000,000

$.14 to $.16

$14,000,000 to $16,000,000

Mexican peso

MXP80,000,000

$.08 to $.11

$ 6,400,000 to $ 8,800,000

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Part 3: Exchange Rate Risk Management

Measuring the Potential Impact of the Currency Exposure The dollar net cash ﬂows of an MNC are generated from a portfolio of currencies. The exposure of the portfolio of currencies can be measured by the standard deviation of the portfolio, which indicates how the portfolio’s value may deviate from what is expected. Consider an MNC that will receive payments in two foreign currencies. The risk (as measured by the standard deviation of monthly percentage changes) of a two-currency portfolio (p) can be estimated as follows: sp 5 "W 2X s2X 1 W 2Y s2Y 1 2WXWY sX sYCORRXY where W X proportion of total portfolio value that is in currency X W Y proportion of total portfolio value that is in currency Y X standard deviation of monthly percentage changes in currency X Y standard deviation of monthly percentage changes in currency Y CORR XY correlation coefﬁcient of monthly percentage changes between currencies X and Y The equation shows that an MNC’s exposure to multiple currencies is inﬂuenced by the variability of each currency and the correlation of movements between the currencies. The volatility of a currency portfolio is positively related to a currency’s volatility and positively related to the correlation between currencies. Each component in the equation that affects a currency portfolio’s risk can be measured using a series of monthly percentage changes in each currency. These components are described in more detail next.

H T T P : // http://www.fednewyork .org/markets/ impliedvolatility.html Measure of exchange rate volatility.

Measurement of Currency Variability. The standard deviation statistic measures the degree of movement for each currency. In any given period, some currencies clearly ﬂuctuate much more than others. For example, the standard deviations of the monthly movements in the Japanese yen and the Swiss franc are typically more than twice that of the Canadian dollar. Based on this information, the potential for substantial deviations from the projected future values is greater for the yen and the Swiss franc than for the Canadian dollar (from a U.S. ﬁrm’s perspective). Some currencies in emerging markets are very volatile. Currency Variability over Time. The variability of a currency will not necessarily remain consistent from one time period to another. Nevertheless, an MNC can at least identify currencies whose values are most likely to be stable or highly variable in the future. For example, the Canadian dollar consistently exhibits lower variability than other currencies, regardless of the period that is assessed.

Measurement of Currency Correlations. The correlations among currency movements can be measured by their correlation coefﬁcients, which indicate the degree to which two currencies move in relation to each other. The extreme case is perfect positive correlation, which is represented by a correlation coefﬁcient equal to 1.00. Correlations can also be negative, reﬂecting an inverse relationship between individual movements, the extreme case being 1.00. Exhibit 10.3 shows the correlation coefﬁcients (based on quarterly data) for several currency pairs. It is clear that some currency pairs exhibit a much higher correlation than others. The European currencies are highly correlated, whereas the Canadian dollar has a relatively low correlation with other currencies. Currency correlations

Chapter 10: Measuring Exposure to Exchange Rate Fluctuations Exhibit 10.3

Correlations among Exchange Rate Movements British Pound

British pound

285

Canadian Dollar

Euro

Japanese Yen

Swedish Krona

1.00

Canadian dollar

.35

1.00

Euro

.91

.48

1.00

Japanese yen

.71

.12

.67

1.00

Swedish krona

.83

.57

.92

.64

1.00

are generally positive; this implies that currencies tend to move in the same direction against the U.S. dollar (though by different degrees). The positive correlation may not always occur on a day-to-day basis, but it appears to hold over longer periods of time for most currencies.

Applying Currency Correlations to Net Cash Flows. The implications of currency correlations for a particular MNC depend on the cash ﬂow characteristics of that MNC. The equation for a portfolio’s standard deviation suggests that positive cash ﬂows in highly correlated currencies result in higher exchange rate risk for the MNC. However, many MNCs have negative net cash ﬂow positions in some currencies; in these situations, the correlations can have different effects on the MNC’s exchange rate risk. Exhibit 10.4 illustrates some common situations for an MNC that has exposure to only two currencies. The concept of currency correlations can be applied to the earlier example of Miami Co.’s net cash ﬂows, as displayed in Exhibit 10.2. Recall that Miami Co. anticipates cash inﬂows in British pounds equivalent to $15 million and cash outﬂows in Swedish kronor equivalent to $15 million. Thus, if a weak-dollar cycle occurs, Miami will be adversely affected by its exposure to the krona, but favorably affected by its pound exposure. During a strong-dollar cycle, it will be adversely affected by the pound exposure but favorably affected by its krona exposure. If Miami expects that these two currencies will move in the same direction and by about the same degree over the next period, its exposures to these two currencies are partially offset. Miami may not be too concerned about its exposure to the Canadian dollar’s movements because the Canadian dollar is somewhat stable with respect to the U.S. dollar over time; risk of substantial depreciation of the Canadian dollar is low. However, the company should be concerned about its exposure to the Mexican peso’s movements because the peso is quite volatile and could depreciate substantially within a short period of time. Miami has no exposure to another currency that will offset the exposure to the peso. Therefore, Miami should seriously consider whether to hedge its expected net cash ﬂow position in pesos. ■

E X A M P L E

Currency Correlations over Time. Exhibit 10.5 shows the trends of exchange rate movements of various currencies against the dollar. Notice how correlations and volatility levels of currencies vary among currencies and over time. An MNC cannot use previous correlations to predict future correlations with perfect accuracy. Nevertheless, some general relationships tend to hold over time. For example, movements in the values of the pound, the euro, and other European currencies against the U.S. dollar tend to be highly correlated in most periods. In addition, the Canadian dollar tends to move independently of other currency movements.

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Part 3: Exchange Rate Risk Management

Exhibit 10.4

Impact of Cash Flow and Correlation Conditions on an MNC’s Exposure

If the MNC’s Expected Cash Flow Situation Is:

And the Currencies Are:

The MNC’s Exposure Is Relatively:

Equal amounts of net inﬂows in two currencies

Highly correlated

High

Equal amounts of net inﬂows in two currencies

Slightly positively correlated

Moderate

Equal amounts of net inﬂows in two currencies

Negatively correlated

Low

A net inﬂow in one currency and a net outﬂow of about the same amount in another currency

Highly correlated

Low

A net inﬂow in one currency and a net outﬂow of about the same amount in another currency

Slightly positively correlated

Moderate

A net inﬂow in one currency and a net outﬂow of about the same amount in another currency

Negatively correlated

High

Assessing Transaction Exposure Based on Value at Risk A related method for assessing exposure is the value-at-risk (VAR) method, which measures the potential maximum one-day loss on the value of positions of an MNC that is exposed to exchange rate movements. Celia Co. will receive 10 million Mexican pesos (MXP) tomorrow as a result of providing consulting services to a Mexican ﬁrm. It wants to determine the maximum one-day loss due to a potential decline in the value of the peso, based on a 95 percent conﬁdence level. It estimates the standard deviation of daily percentage changes of the Mexican peso to be 1.2 percent over the last 100 days. If these daily percentage changes are normally distributed, the maximum one-day loss is determined by the lower boundary (the left tail) of the probability distribution, which is about 1.65 standard deviations away from the expected percentage change in the peso. Assuming an expected percentage change of 0 percent (implying no expected change in the peso) during the next day, the maximum one-day loss is

E X A M P L E

Maximum one-day loss 5 E 1 et 2 2 1 1.65 3 sMXP 2 5 0% 2 1 1.65 3 1.2% 2 5 2.0198, or 21.98% Assume the spot rate of the peso is $.09. The maximum one-day loss of 1.98 percent implies a peso value of

Peso value based on maximum one-day loss 5 S 3 3 1 1 E 1 et 2 4 5 $.09 3 3 1 1 1 2.0198 2 4 5 $.088218 Thus, if the maximum one-day loss occurs, the peso’s value will have declined to $.088218. The dollar value of this maximum one-day loss is dependent on Celia’s position in Mexican pesos. For example, if Celia has MXP10 million, this represents a value of $900,000 (at $.09 per peso), so a decline in the peso’s value of 1.98 percent would result in a loss of $900,000 1.98% $17,820. ■

Factors That Affect the Maximum One-Day Loss. The maximum one-day loss of a currency is dependent on three factors. First, it is dependent on the expected percentage change in the currency for the next day. If the expected

Chapter 10: Measuring Exposure to Exchange Rate Fluctuations Exhibit 10.5

Movements of Selected Currencies against the Dollar

.60

1.00 .95

Chinese Yuan

Canadian Dollar .50 .40

.85

$ per Unit

$ per Unit

.90

.80 .75

.30 .20

.70 .10

.65

.11 .10 .09 .08 .07 .06 .05 .04 .03 .02 .01 .00

1990 92 94 96 98 00 02 04

.00 06 08

Indian Rupee

$ per Unit

$ per Unit

.60

1990 92 94 96 98 00 02 04

06 08

.80 .70

06 08

Japanese Yen

1990 92 94 96 98 00 02 04

06 08

.20 Singapore Dollar

.18

Swedish Krona

.16

.60

.14

.50

$ per Unit

$ per Unit

.012 .011 .010 .009 .008 .007 .006 .005 .004 .003 .002 .001 .000

1990 92 94 96 98 00 02 04

.40 .30

.12 .10 .08 .06

.20

.04

.10

.02

.00

.00 1990 92 94 96 98 00 02 04

06 08

1990 92 94 96 98 00 02 04

06 08

287

288

Part 3: Exchange Rate Risk Management

outcome in the previous example is .2 percent instead of 0 percent, the maximum loss over the one-day period is Maximum one-day loss 5 E 1 et 2 2 1 1.65 3 sMXP 2 5 2.2% 2 1 1.65 3 1.2% 2 5 2.0218, or 22.18% Second, the maximum one-day loss is dependent on the conﬁdence level used. A higher conﬁdence level will cause a more pronounced maximum one-day loss, holding other factors constant. If the conﬁdence level in the example is 97.5 percent instead of 95 percent, the lower boundary is 1.96 standard deviations from the expected percentage change in the peso. Thus, the maximum one-day loss is Maximum one-day loss 5 E 1 et 2 2 1 1.96 3 sMXP 2 5 0% 2 1 1.96 3 1.2% 2 5 2.02352, or 22.352% Third, the maximum one-day loss is dependent on the standard deviation of the daily percentage changes in the currency over a previous period. If the peso’s standard deviation in the example is 1 percent instead of 1.2 percent, the maximum one-day loss (based on the 95 percent conﬁdence interval) is Maximum one-day loss 5 E 1 et 2 2 1 1.65 3 sMXP 2 5 0% 2 1 1.65 3 1% 2 5 2.0165, or 21.65%

Applying VAR to Longer Time Horizons. The VAR method can also be used to assess exposure over longer time horizons. The standard deviation should be estimated over the time horizon in which the maximum loss is to be measured. Lada, Inc., expects to receive Mexican pesos in one month for products that it exported. It wants to determine the maximum one-month loss due to a potential decline in the value of the peso, based on a 95 percent conﬁdence level. It estimates the standard deviation of monthly percentage changes of the Mexican peso to be 6 percent over the last 40 months. If these monthly percentage changes are normally distributed, the maximum one-month loss is determined by the lower boundary (the left tail) of the probability distribution, which is about 1.65 standard deviations away from the expected percentage change in the peso. Assuming an expected percentage change of 1 percent during the next month, the maximum onemonth loss is

E X A M P L E

Maximum one-month loss 5 E 1 et 2 2 1 1.65 3 sMXP 2 5 21% 2 1 1.65 3 6% 2 5 2.109, or 210.9% If Lada, Inc., is uncomfortable with the magnitude of the potential loss, it can hedge its position as explained in the next chapter. ■

Applying VAR to Transaction Exposure of a Portfolio. Since MNCs are commonly exposed to more than one currency, they may apply the VAR method to a currency portfolio. When considering multiple currencies, software packages can be used to perform the computations. An example of applying VAR to a two-currency portfolio is provided here.

Chapter 10: Measuring Exposure to Exchange Rate Fluctuations

289

Benou, Inc., a U.S. exporting ﬁrm, expects to receive substantial payments denominated in Indonesian rupiah and Thai baht in one month. Based on today’s spot rates, the dollar value of the funds to be received is estimated at $600,000 for the rupiah and $400,000 for the baht. Thus, Benou is exposed to a currency portfolio weighted 60 percent in rupiah and 40 percent in baht. Benou wants to determine the maximum expected one-month loss due to a potential decline in the value of these currencies, based on a 95 percent conﬁdence level. Based on data for the last 20 months, it estimates the standard deviation of monthly percentage changes to be 7 percent for the rupiah and 8 percent for the baht, and a correlation coefﬁcient of .50 between the rupiah and baht. The portfolio’s standard deviation is

E X A M P L E

sp 5 " 1 .36 2 1 .0049 2 1 1 .16 2 1 .0064 2 1 2 1 .60 2 1 .40 2 1 .07 2 1 .08 2 1 .50 2 5 about .0643, or about 6.43% If the monthly percentage changes of each currency are normally distributed, the monthly percentage changes of the portfolio should be normally distributed. The maximum one-month loss of the currency portfolio is determined by the lower boundary (the left tail) of the probability distribution, which is about 1.65 standard deviations away from the expected percentage change in the currency portfolio. Assuming an expected percentage change of 0 percent for each currency during the next month (and therefore an expected change of zero for the portfolio), the maximum one-month loss is

Maximum one-month loss of currency portfolio 5 E 1 et 2 2 1 1.65 3 sp 2 5 0% 2 1 1.65 3 6.43% 2 5 about 2.1061, or about 210.61% Compare this maximum one-month loss to that of the rupiah or the baht:

Maximum one-month loss of rupiah 5 0% 2 1 1.65 3 7% 2 5 2.1155, or 211.55% Maximum one-month loss of baht 5 0% 2 1 1.65 3 8% 2 5 2.132, or 213.2% Notice that the maximum one-month loss for the portfolio is lower than the maximum loss for either individual currency, which is attributed to the diversiﬁcation effects. Even if one currency experiences its maximum loss in a given month, the other currency is not likely to experience its maximum loss in that same month. The lower the correlation between the movements in the two currencies, the greater are the diversiﬁcation beneﬁts. Given the maximum losses calculated here, Benou, Inc., may decide to hedge its rupiah position, its baht position, neither position, or both positions. The decision of whether to hedge is discussed in the next chapter. ■

Limitations of VAR. The VAR method presumes that the distribution of exchange rate movements is normal. If the distribution of exchange rate movements is not normal, the estimate of the maximum expected loss is subject to error. In addition, the VAR method assumes that the volatility (standard deviation) of exchange rate movements is stable over time. If exchange rate movements are less volatile in the past than in the future, the estimated maximum expected loss derived from the VAR method will be underestimated.

Economic Exposure The value of a ﬁ rm’s cash ﬂows can be affected by exchange rate movements if it executes transactions in foreign currencies, receives revenue from foreign customers, or is subject to foreign competition. The sensitivity of the ﬁ rm’s cash ﬂows to exchange

290

Part 3: Exchange Rate Risk Management

rate movements is referred to as economic exposure (also sometimes referred to as operating exposure). Transaction exposure is a subset of economic exposure. But economic exposure also includes other ways in which a ﬁ rm’s cash ﬂows can be affected by exchange rate movements. Intel invoices about 65 percent of its chip exports in U.S. dollars. Although Intel is not subject to transaction exposure for its dollar-denominated exports, it is subject to economic exposure. If the euro weakens against the dollar, the European importers of those chips from Intel will need more euros to pay for them. These importers are subject to transaction exposure and economic exposure. As their costs of importing the chips increase in response to the weak euro, they may decide to purchase chips from European manufacturers instead. Consequently, Intel’s cash ﬂows from its exports will be reduced, even though these exports are invoiced in dollars. ■

E X A M P L E

Exhibit 10.6 provides examples of how a ﬁ rm is subject to economic exposure. Consider each example by itself as if the ﬁ rm had no other international business. Since the ﬁ rst two examples involve contractual transactions in foreign currencies, they reﬂect transaction exposure. The remaining examples do not involve contractual transactions in foreign currencies and therefore do not reﬂect transaction exposure. Yet, they do reﬂect economic exposure because they affect the ﬁ rm’s cash ﬂows. If a ﬁ rm experienced the exposure described in the third and fourth examples but did not have any contractual transactions in foreign currencies, it would be subject to economic exposure without being subject to transaction exposure. Some of the more common international business transactions that typically subject an MNC’s cash ﬂows to economic exposure are listed in the ﬁrst column of Exhibit 10.7. Transactions listed in the exhibit that require conversion of currencies, and thus reﬂect transaction exposure, include exports denominated in foreign currency, interest received from foreign investments, imports denominated in foreign currency, and interest owed on foreign loans. The other transactions, which do not require conversion of currencies and therefore do not reﬂect transaction exposure, are also a form of economic exposure because the cash ﬂows resulting from these transactions can be inﬂuenced by exchange rate movements. Exchange rate movements can have as large an effect on cash ﬂows from these transactions as on cash ﬂows from transactions that require currency conversion. The second and third columns of Exhibit 10.7 indicate how each transaction can be affected by the appreciation and depreciation, respectively, of the ﬁrm’s home (local) currency. The next sections discuss these effects in turn.

Exhibit 10.6

Examples That Subject a Firm to Economic Exposure

A U.S. Firm:

U.S. Firm’s Dollar Cash Flows Are Adversely Affected If the:

1. has a contract to export products in which it agreed to accept euros.

euro depreciates.

2. has a contract to import materials that are priced in Mexican pesos.

peso appreciates.

3. exports products to the United Kingdom that are priced in dollars, and competitors are located in the United Kingdom.

pound depreciates (causing some customers to switch to the competitors).

4. sells products to local customers, and its main competitor is based in Belgium.

euro depreciates (causing some customers to switch to the competitors).

Chapter 10: Measuring Exposure to Exchange Rate Fluctuations Exhibit 10.7

291

Economic Exposure to Exchange Rate Fluctuations

Transactions That Inﬂuence the Firm’s Local Currency Inﬂows

Impact of Local Currency Appreciation on Transactions

Impact of Local Currency Depreciation on Transactions

Local sales (relative to foreign competition in local markets)

Decrease

Increase

Firm’s exports denominated in local currency

Decrease

Increase

Firm’s exports denominated in foreign currency

Decrease

Increase

Interest received from foreign investments

Decrease

Increase

Firm’s imported supplies denominated in local currency

No change

No change

Firm’s imported supplies denominated in foreign currency

Decrease

Increase

Interest owed on foreign funds borrowed

Decrease

Increase

Transactions That Inﬂuence the Firm’s Local Currency Outﬂows

Economic Exposure to Local Currency Appreciation The following discussion is related to the second column of Exhibit 10.7. Local sales (in the ﬁrm’s home country) are expected to decrease if the local (home) currency appreciates because the ﬁrm will face increased foreign competition. Local customers will be able to obtain foreign substitute products cheaply with their strengthened currency. Cash inﬂows from exports denominated in the local currency will also likely be reduced as a result of appreciation in that currency because foreign importers will need more of their own currency to pay for these products. Any interest or dividends received from foreign investments will also convert to a reduced amount if the local currency has strengthened. With regard to the ﬁrm’s cash outﬂows, the cost of imported supplies denominated in the local currency will not be directly affected by changes in exchange rates. If the local currency appreciates, however, the cost of imported supplies denominated in the foreign currency will be reduced. In addition, any interest to be paid on ﬁnancing in foreign currencies will be reduced (in terms of the local currency) if the local currency appreciates because the strengthened local currency will be exchanged for the foreign currency to make the interest payments. Thus, appreciation in the ﬁrm’s local currency causes a reduction in both cash inﬂows and outﬂows. The impact on a ﬁrm’s net cash ﬂows will depend on whether the inﬂow transactions are affected more or less than the outﬂow transactions. If, for example, the ﬁrm is in the exporting business but obtains its supplies and borrows funds locally, its inﬂow transactions will be reduced by a greater degree than its outﬂow transactions. In this case, net cash ﬂows will be reduced. Conversely, cash inﬂows of a ﬁrm concentrating its sales locally with little foreign competition will not be severely reduced by appreciation of the local currency. If such a ﬁrm obtains supplies and borrows funds overseas, its outﬂows will be reduced. Overall, this ﬁrm’s net cash ﬂows will be enhanced by the appreciation of its local currency.

Economic Exposure to Local Currency Depreciation If the ﬁrm’s local currency depreciates (see the third column of Exhibit 10.7), its transactions will be affected in a manner opposite to the way they are inﬂuenced by appreciation. Local sales should increase due to reduced foreign competition because

292

Part 3: Exchange Rate Risk Management

prices denominated in strong foreign currencies will seem high to the local customers. The ﬁrm’s exports denominated in the local currency will appear cheap to importers, thereby increasing foreign demand for those products. Even exports denominated in the foreign currency can increase cash ﬂows because a given amount in foreign currency inﬂows to the ﬁrm will convert to a larger amount of the local currency. In addition, interest or dividends from foreign investments will now convert to more of the local currency. With regard to cash outﬂows, imported supplies denominated in the local currency will not be directly affected by any change in exchange rates. The cost of imported supplies denominated in the foreign currency will rise, however, because more of the weakened local currency will be required to obtain the foreign currency needed. Any interest payments paid on ﬁnancing in foreign currencies will increase. In general, depreciation of the ﬁrm’s local currency causes an increase in both cash inﬂows and outﬂows. A ﬁrm that concentrates on exporting and obtains supplies and borrows funds locally will likely beneﬁt from a depreciated local currency. This is the case for Caterpillar, Ford, and General Motors in periods when the dollar weakens substantially against most major currencies. Conversely, a ﬁrm that concentrates on local sales, has very little foreign competition, and obtains foreign supplies (denominated in foreign currencies) will likely be hurt by a depreciated local currency.

Economic Exposure of Domestic Firms Although our focus is on the ﬁnancial management of MNCs, even purely domestic ﬁrms are affected by economic exposure. Burlington, Inc., is a U.S. manufacturer of steel that purchases all of its supplies locally and sells all of its steel locally. Because its transactions are solely in the local currency, Burlington is not subject to transaction exposure. It is subject to economic exposure, however, because it faces foreign competition in its local markets. If the exchange rate of the foreign competitor’s invoice currency depreciates against the dollar, customers interested in steel products will shift their purchases toward the foreign steel producer. Consequently, demand for Burlington’s steel will likely decrease, and so will its net cash inﬂows. Thus, Burlington is subject to economic exposure even though it is not subject to transaction exposure. ■

E X A M P L E

Measuring Economic Exposure Since MNCs are affected by economic exposure, they should assess the potential degree of exposure that exists and then determine whether to insulate themselves against it.

Using Sensitivity Analysis to Measure Economic Exposure. One method of measuring an MNC’s economic exposure is to separately consider how sales and expense categories are affected by various exchange rate scenarios. Madison Co. is a U.S.-based MNC that purchases most of its materials from Canada and generates a small portion of its sales from exporting to Canada. Its U.S. sales are denominated in U.S. dollars, while its Canadian sales are denominated in Canadian dollars (C$). The estimates of its cash flows are shown in Exhibit 10.8, separated by country. Assume that Madison Co. expects three possible exchange rates for the Canadian dollar over the period of concern: (1) $.75, (2) $.80, or (3) $.85. These scenarios are separately analyzed in the second, third, and fourth columns of Exhibit 10.9. Row 1 is constant across scenarios since the U.S. business sales are not affected by exchange rate movements. In row 2, the estimated U.S. dollar sales due to the Canadian business are determined by converting the estimated Canadian dollar sales into U.S. dollars. Row 3 is the sum of the U.S. dollar sales in rows 1 and 2.

E X A M P L E

Chapter 10: Measuring Exposure to Exchange Rate Fluctuations

293

Row 4 is constant across scenarios since the cost of materials in the United States is not affected by exchange rate movements. In row 5, the estimated U.S. dollar cost of materials due to the Canadian business is determined by converting the estimated Canadian cost of materials into U.S. dollars. Row 6 is the sum of the U.S. dollar cost of materials in rows 4 and 5. Row 7 is constant across scenarios since the U.S. operating expenses are not affected by exchange rate movements. Row 8 is constant across scenarios since the interest expense on U.S. debt is not affected by exchange rate movements. In row 9, the estimated U.S. dollar interest expense from Canadian debt is determined by converting the estimated Canadian interest expenses into U.S. dollars. Row 10 is the sum of the U.S. dollar interest expenses in rows 8 and 9. The effect of exchange rates on Madison’s revenues and costs can now be reviewed. Exhibit 10.9 illustrates how the dollar value of Canadian sales and Canadian cost of materials would increase as a result of a stronger Canadian dollar. Because Madison’s Canadian

Exhibit 10.8 Estimated Sales and Expenses for Madison’s U.S. and Canadian Business Segments (in Millions) U.S. Business Sales

$320

C$4

Cost of materials

$50

C$200

Operating expenses

$60

—

$3

C$10

$207

C$206

Interest expenses Cash ﬂows

Exhibit 10.9

Canadian Business

Impact of Possible Exchange Rates on Cash Flows of Madison Co. (in Millions) Exchange Rate Scenario C$1 $.75

C$1 $.80

C$1 $.85

Sales (1) U.S. sales (2) Canadian sales

$320.00 C$4

(3) Total sales in U.S. $

$

3.00

$320.00 C$4

$

3.20

$320.00 C$4

$

3.40

$323.00

$323.20

$323.40

$ 50.00

$ 50.00

$ 50.00

Cost of Materials and Operating Expenses (4) U.S. cost of materials (5) Canadian cost of materials

C$200

$150.00

C$200

$160.00

C$200

$170.00

(6) Total cost of materials in U.S. $

$200.00

$210.00

$220.00

(7) Operating expenses

$ 60.00

$ 60.00

$ 60.00

$ 3

$ 3

$ 3

Interest Expenses (8) U.S. interest expenses (9) Canadian interest expenses (10) Total interest expenses in U.S. $ Cash Flows in U.S. Dollars before Taxes

C$10

$ 7.5

C$10

$ 8

C$10

$ 8.50

$10.50

$11.00

$11.50

$52.50

$42.20

$31.90

294

Part 3: Exchange Rate Risk Management cost of materials exposure (C$200 million) is much greater than its Canadian sales exposure (C$4 million),a strong Canadian dollar has a negative overall impact on its cash flow. The total amount in U.S. dollars needed to make interest payments is also higher when the Canadian dollar is stronger. In general, Madison Co., would be adversely affected by a stronger Canadian dollar. It would be favorably affected by a weaker Canadian dollar because the reduced value of total sales would be more than offset by the reduced cost of materials and interest expenses. ■

A general conclusion from this example is that ﬁrms with more (less) in foreign costs than in foreign revenue will be unfavorably (favorably) affected by a stronger foreign currency. The precise anticipated impact, however, can be determined only by utilizing the procedure described here or some alternative procedure. The example is based on a one-period time horizon. If ﬁrms have developed forecasts of sales, expenses, and exchange rates for several periods ahead, they can assess their economic exposure over time. Their economic exposure will be affected by any change in operating characteristics over time.

Using Regression Analysis to Measure Economic Exposure. A ﬁrm’s economic exposure to currency movements can also be assessed by applying regression analysis to historical cash ﬂow and exchange rate data as follows: PCFt a 0 a1et mt where PCFt percentage change in inﬂation-adjusted cash ﬂows measured in the ﬁrm’s home currency over period t et percentage change in the direct exchange rate of the currency over period t mt random error term a 0 intercept a1 slope coefﬁcient The regression coefﬁcient a1, estimated by regression analysis, indicates the sensitivity of PCFt to et. If the coefﬁcient is positive and signiﬁcant, this implies that a positive change in the currency’s value has a favorable effect on the ﬁ rm’s cash ﬂows. If the coefﬁcient is negative and signiﬁcant, this implies an inverse relationship between the change in the currency’s value and the ﬁ rm’s cash ﬂows. If the ﬁrm anticipates no major adjustments in its operating structure, it will expect the sensitivity detected from regression analysis to be somewhat similar in the future. This regression model can be revised to handle more complex situations. For example, if additional currencies are to be assessed, they can be included in the model as additional independent variables. Each currency’s impact is measured by estimating its respective regression coefﬁcient. If an MNC is inﬂuenced by numerous currencies, it can measure the sensitivity of PCFt to an index (or composite) of currencies. The analysis just described for a single currency can also be extended over separate subperiods, as the sensitivity of a ﬁrm’s cash ﬂows to a currency’s movements may change over time. This would be indicated by a shift in the regression coefﬁcient, which may occur if the ﬁrm’s exposure to exchange rate movements changes. Some MNCs may prefer to use their stock price as a proxy for the ﬁrm’s value and then assess how their stock price changes in response to currency movements. Regression analysis could also be applied to this situation by replacing PCFt with the percentage change in stock price in the model speciﬁed here.

Chapter 10: Measuring Exposure to Exchange Rate Fluctuations

295

Some researchers, including Adler and Dumas,1 suggest the use of regression analysis for this purpose. By assigning stock returns as the dependent variable, regression analysis can indicate how the ﬁrm’s value is sensitive to exchange rate ﬂuctuations. Some companies may assess the impact of exchange rates on particular corporate characteristics, such as earnings, exports, or sales. Toyota Motor Corp. measures the sensitivity of its exports to the yen exchange rate (relative to the U.S. dollar). Consequently, it can determine how the level of exports may change in response to potential changes in the value of the yen. This information is useful when Toyota determines its production level and manages its inventory. ■

E X X A M P L E

Translation Exposure An MNC creates its ﬁnancial statements by consolidating all of its individual subsidiaries’ ﬁnancial statements. A subsidiary’s ﬁnancial statement is normally measured in its local currency. To be consolidated, each subsidiary’s ﬁnancial statement must be translated into the currency of the MNC’s parent. Since exchange rates change over time, the translation of the subsidiary’s ﬁnancial statement into a different currency is affected by exchange rate movements. The exposure of the MNC’s consolidated ﬁnancial statements to exchange rate ﬂuctuations is known as translation exposure. In particular, subsidiary earnings translated into the reporting currency on the consolidated income statement are subject to changing exchange rates. To translate earnings, MNCs use a process established by the Financial Accounting Standards Board (FASB). The prevailing guidelines are set by FASB 52 for translation and by FASB 133 for valuing existing currency derivative contracts.

Does Translation Exposure Matter? The relevance of translation exposure can be argued based on a cash ﬂow perspective or a stock price perspective.

Cash Flow Perspective. Translation of ﬁnancial statements for consolidated reporting purposes does not by itself affect an MNC’s cash ﬂows. The subsidiary earnings do not actually have to be converted into the parent’s currency. If a subsidiary’s local currency is currently weak, the earnings could be retained rather than converted and sent to the parent. The earnings could be reinvested in the subsidiary’s country if feasible opportunities exist. An MNC’s parent, however, may rely on funding from periodic remittances of earnings by the subsidiary. Even if the subsidiary does not need to remit any earnings today, it will remit earnings at some point in the future. To the extent that today’s spot rate serves as a forecast of the spot rate that will exist when earnings are remitted, a weak foreign currency today results in a forecast of a weak exchange rate at the time that the earnings are remitted. In this case, the expected future cash ﬂows are affected, so translation exposure is relevant. Stock Price Perspective. Many investors tend to use earnings when valuing ﬁrms, either by deriving estimates of expected cash ﬂows from previous earnings or by applying an industry price-earnings (P/E) ratio to expected annual earnings to derive a value per share of stock. Since an MNC’s translation exposure affects its consolidated earnings, it can affect the MNC’s valuation. 1

Michael Adler and Bernard Dumas, “Exposure to Currency Risk: Deﬁnition and Measurement,” Financial Management, 13, no. 2 (Summer 1984): 41–50.

296

Part 3: Exchange Rate Risk Management

Determinants of Translation Exposure Some MNCs are subject to a greater degree of translation exposure than others. An MNC’s degree of translation exposure is dependent on the following: • The proportion of its business conducted by foreign subsidiaries • The locations of its foreign subsidiaries • The accounting methods that it uses

Proportion of Its Business Conducted by Foreign Subsidiaries. The greater the percentage of an MNC’s business conducted by its foreign subsidiaries, the larger the percentage of a given ﬁnancial statement item that is susceptible to translation exposure. Locus Co. and Zeuss Co. each generate about 30 percent of their sales from foreign countries. However, Locus Co. generates all of its international business by exporting, whereas Zeuss Co. has a large Mexican subsidiary that generates all of its international business. Locus Co. is not subject to translation exposure (although it is subject to economic exposure), while Zeuss has substantial translation exposure. ■

E X A M P L E

Locations of Foreign Subsidiaries. The locations of the subsidiaries can also inﬂuence the degree of translation exposure because the ﬁnancial statement items of each subsidiary are typically measured by the home currency of the subsidiary’s country. Zeuss Co. and Canton Co. each have one large foreign subsidiary that generates about 30 percent of their respective sales. However, Zeuss Co. is subject to a much higher degree of translation exposure because its subsidiary is based in Mexico, and the peso’s value is subject to a large decline. In contrast, Canton’s subsidiary is based in Canada, and the Canadian dollar is very stable against the U.S. dollar. ■

E X A M P L E

Accounting Methods. An MNC’s degree of translation exposure can be greatly affected by the accounting procedures it uses to translate when consolidating ﬁnancial statement data. Many of the important consolidated accounting rules for U.S.-based MNCs are based on FASB 52: 1. The functional currency of an entity is the currency of the economic environment in which the entity operates. 2. The current exchange rate as of the reporting date is used to translate the assets and liabilities of a foreign entity from its functional currency into the reporting currency. 3. The weighted average exchange rate over the relevant period is used to translate revenue, expenses, and gains and losses of a foreign entity from its functional currency into the reporting currency. 4. Translated income gains or losses due to changes in foreign currency values are not recognized in current net income but are reported as a second component of stockholder’s equity; an exception to this rule is a foreign entity located in a country with high inﬂation. 5. Realized income gains or losses due to foreign currency transactions are recorded in current net income, although there are some exceptions. Under FASB 52, consolidated earnings are sensitive to the functional currency’s weighted average exchange rate.

Chapter 10: Measuring Exposure to Exchange Rate Fluctuations

297

A British subsidiary of Providence, Inc., earned £10 million in year 1 and £10 million in year 2. When these earnings are consolidated along with other subsidiary earnings, they are translated into U.S. dollars at the weighted average exchange rate in that year. Assume the weighted average exchange rate is $1.70 in year 1 and $1.50 in year 2. The translated earnings for each reporting period in U.S. dollars are determined as follows:

E X A M P L E

Reporting Period

Local Earnings of British Subsidiary

Weighted Average Exchange Rate of Pound over the Reporting Period

Translated U.S. Dollar Earnings of British Subsidiary

Year 1

£10,000,000

$1.70

$17,000,000

Year 2

£10,000,000

$1.50

$15,000,000

Notice that even though the subsidiary’s earnings in pounds were the same each year, the translated consolidated dollar earnings were reduced by $2 million in year 2. The discrepancy here is due to the change in the weighted average of the British pound exchange rate. The drop in earnings is not the fault of the subsidiary but rather of the weakened British pound that makes its year 2 earnings look small (when measured in U.S. dollars). ■

Examples of Translation Exposure Consolidated earnings of Black & Decker, The Coca-Cola Co., and other MNCs are very sensitive to exchange rates because more than a third of their assets and sales are overseas. Their earnings in foreign countries are reduced when translated if foreign currencies depreciate against the U.S. dollar. In the 2000–2001 period, the weakness of the euro caused several U.S.-based MNCs to report lower earnings than they had expected. In September 2000, when DuPont announced that its consolidated earnings would be affected by its translation exposure to the euro, investors responded quickly by dumping DuPont’s shares. The stock price of DuPont declined 10 percent on that day. Other MNCs including Colgate-Palmolive, Gillette, Goodyear, and McDonald’s followed with similar announcements. In the 2002–2007 period, the euro strengthened, which had a favorable translation effect on the consolidated earnings of U.S.-based MNCs that have foreign subsidiaries in the euro zone. In some quarters over this period, more than half of the increase in reported earnings by MNCs was due to the translation effect.

SUMMARY ■ MNCs with less risk can obtain funds at lower ﬁnancing costs. Since they may experience more volatile cash ﬂows because of exchange rate movements, exchange rate risk can affect their ﬁnancing costs. Thus, MNCs may beneﬁt from hedging exchange rate risk.

sure by determining their future payables and receivables positions in various currencies, along with the variability levels and correlations of these currencies. From this information, they can assess how their revenue and costs may change in response to various exchange rate scenarios.

■ Transaction exposure is the exposure of an MNC’s future cash transactions to exchange rate movements. MNCs can measure their transaction expo-

■ Economic exposure is any exposure of an MNC’s cash ﬂows (direct or indirect) to exchange rate movements. MNCs can attempt to measure their economic

298

Part 3: Exchange Rate Risk Management

exposure by determining the extent to which their cash ﬂows will be affected by their exposure to each foreign currency. ■ Translation exposure is the exposure of an MNC’s consolidated ﬁnancial statements to exchange rate

POINT

movements. To measure translation exposure, MNCs can forecast their earnings in each foreign currency and then determine how their earnings could be affected by the potential exchange rate movements of each currency.

COUNTER-POINT

Should Investors Care about an MNC’s Translation Exposure? Point No. The present value of an MNC’s cash ﬂows is based on the cash ﬂows that the parent receives. Any impact of the exchange rates on the ﬁnancial statements is not important unless cash ﬂows are affected. MNCs should focus their energy on assessing the exposure of their cash ﬂows to exchange rate movements and should not be concerned with the exposure of their ﬁnancial statements to exchange rate movements. Value is about cash ﬂows, and investors focus on value. Counter-Point Investors do not have sufﬁcient ﬁnancial data to derive cash ﬂows. They commonly use earnings as a base, and if earnings are distorted, their estimates of cash ﬂows will be also. If they underesti-

SELF

mate cash ﬂows because of how exchange rates affected the reported earnings, they may underestimate the value of the MNC. Even if the value is corrected in the future once the market realizes how the earnings were distorted, some investors may have sold their stock by the time the correction occurs. Investors should be concerned about an MNC’s translation exposure. They should recognize that the earnings of MNCs with large translation exposure may be more distorted than the earnings of MNCs with low translation exposure. Who Is Correct? Use the Internet to learn more about this issue. Which argument do you support?

TEST

Answers are provided in Appendix A at the back of the text. 1. Given that shareholders can diversify away an individual ﬁrm’s exchange rate risk by investing in a variety of ﬁrms, why are ﬁrms concerned about exchange rate risk? 2. Bradley, Inc., considers importing its supplies from either Canada (denominated in C$) or Mexico (denominated in pesos) on a monthly basis. The quality is the same for both sources. Once the ﬁrm completes the agreement with a supplier, it will be obligated to continue using that supplier for at least 3 years. Based on existing exchange rates, the dollar amount to be paid (including transportation costs) will be the same. The ﬁrm has no other exposure to exchange rate movements. Given that the ﬁrm prefers to have less exchange rate risk, which alternative is preferable? Explain. 3. Assume your U.S. ﬁrm currently exports to Mexico on a monthly basis. The goods are priced in

pesos. Once material is received from a source, it is quickly used to produce the product in the United States, and then the product is exported. Currently, you have no other exposure to exchange rate risk. You have a choice of purchasing the material from Canada (denominated in C$), from Mexico (denominated in pesos), or from within the United States (denominated in U.S. dollars). The quality and your expected cost are similar across the three sources. Which source is preferable, given that you prefer minimal exchange rate risk? 4. Using the information in the previous question, consider a proposal to price the exports to Mexico in dollars and to use the U.S. source for material. Would this proposal eliminate the exchange rate risk? 5. Assume that the dollar is expected to strengthen against the euro over the next several years. Explain how this will affect the consolidated earnings of U.S.-based MNCs with subsidiaries in Europe.

Chapter 10: Measuring Exposure to Exchange Rate Fluctuations

QUESTIONS

AND

299

A P P L I CAT I O N S

1. Transaction versus Economic Exposure. Compare and contrast transaction exposure and economic exposure. Why would an MNC consider examining only its “net” cash ﬂows in each currency when assessing its transaction exposure? 2. Assessing Transaction Exposure. Your employer, a large MNC, has asked you to assess its transaction exposure. Its projected cash ﬂows are as follows for the next year. Danish krone inﬂows equal DK50,000,000 while outﬂows equal DK40,000,000. British pound inﬂows equal £2,000,000 while outﬂows equal £1,000,000. The spot rate of the krone is $.15, while the spot rate of the pound is $1.50. Assume that the movements in the Danish krone and the British pound are highly correlated. Provide your assessment as to your ﬁrm’s degree of transaction exposure (as to whether the exposure is high or low). Substantiate your answer. 3. Factors That Affect a Firm’s Transaction Exposure. What factors affect a ﬁrm’s degree of transaction exposure in a particular currency? For each factor, explain the desirable characteristics that would reduce transaction exposure. 4. Currency Correlations. Kopetsky Co. has net receivables in several currencies that are highly correlated with each other. What does this imply about the ﬁrm’s overall degree of transaction exposure? Are currency correlations perfectly stable over time? What does your answer imply about Kopetsky Co. or any other ﬁrm using past data on correlations as an indicator for the future? 5. Currency Effects on Cash Flows. How should appreciation of a ﬁrm’s home currency generally affect its cash inﬂows? How should depreciation of a ﬁrm’s home currency generally affect its cash outﬂows? 6. Transaction Exposure. Fischer, Inc., exports products from Florida to Europe. It obtains supplies and borrows funds locally. How would appreciation of the euro likely affect its net cash ﬂows? Why? 7. Exposure of Domestic Firms. Why are the cash ﬂows of a purely domestic ﬁrm exposed to exchange rate ﬂuctuations? 8. Measuring Economic Exposure. Memphis Co. hires you as a consultant to assess its degree of economic exposure to exchange rate ﬂuctuations. How would you handle this task? Be speciﬁc.

9. Factors That Affect a Firm’s Translation Exposure. What factors affect a ﬁrm’s degree of translation exposure? Explain how each factor inﬂuences translation exposure. 10. Translation Exposure. Consider a period in which the U.S. dollar weakens against the euro. How will this affect the reported earnings of a U.S.-based MNC with European subsidiaries? Consider a period in which the U.S. dollar strengthens against most foreign currencies. How will this affect the reported earnings of a U.S.-based MNC with subsidiaries all over the world? 11. Transaction Exposure. Aggie Co. produces chemicals. It is a major exporter to Europe, where its main competition is from other U.S. exporters. All of these companies invoice the products in U.S. dollars. Is Aggie’s transaction exposure likely to be signiﬁcantly affected if the euro strengthens or weakens? Explain. If the euro weakens for several years, can you think of any change that might occur in the global chemicals market? 12. Economic Exposure. Longhorn Co. produces hospital equipment. Most of its revenues are in the United States. About half of its expenses require outﬂows in Philippine pesos (to pay for Philippine materials). Most of Longhorn’s competition is from U.S. ﬁrms that have no international business at all. How will Longhorn Co. be affected if the peso strengthens? 13. Economic Exposure. Lubbock, Inc., produces furniture and has no international business. Its major competitors import most of their furniture from Brazil and then sell it out of retail stores in the United States. How will Lubbock, Inc., be affected if Brazil’s currency (the real) strengthens over time? 14. Economic Exposure. Sooner Co. is a U.S. wholesale company that imports expensive high-quality luggage and sells it to retail stores around the United States. Its main competitors also import highquality luggage and sell it to retail stores. None of these competitors hedge their exposure to exchange rate movements. Why might Sooner’s market share be more volatile over time if it hedges its exposure? 15. PPP and Economic Exposure. Boulder, Inc., exports chairs to Europe (invoiced in U.S. dollars) and competes against local European companies. If purchasing power parity exists, why would Boulder not beneﬁt from a stronger euro?

300

Part 3: Exchange Rate Risk Management

16. Measuring Changes in Economic Exposure. Toyota Motor Corp. measures the sensitivity of its exports to the yen exchange rate (relative to the U.S. dollar). Explain how regression analysis could be used for such a task. Identify the expected sign of the regression coefﬁcient if Toyota primarily exports to the United States. If Toyota established plants in the United States, how might the regression coefﬁcient on the exchange rate variable change? 17. Impact of Exchange Rates on Earnings. Cieplak, Inc., is a U.S.-based MNC that has expanded into Asia. Its U.S. parent exports to some Asian countries, with its exports denominated in the Asian currencies. It also has a large subsidiary in Malaysia that serves that market. Offer at least two reasons related to exposure to exchange rates that explain why Cieplak’s earnings were reduced during the Asian crisis. Advanced Questions 18. Speculating Based on Exposure. During the Asian crisis in 1998, there were rumors that China would weaken its currency (the yuan) against the U.S. dollar and many European currencies. This caused investors to sell stocks in Asian countries such as Japan, Taiwan, and Singapore. Offer an intuitive explanation for such an effect. What types of Asian ﬁrms would have been affected the most? 19. Comparing Transaction and Economic Exposure. Erie Co. has most of its business in the United States, except that it exports to Belgium. Its exports were invoiced in euros (Belgium’s currency) last year. It has no other economic exposure to exchange rate risk. Its main competition when selling to Belgium’s customers is a company in Belgium that sells similar products, denominated in euros. Starting today, Erie Co. plans to adjust its pricing strategy to invoice its exports in U.S. dollars instead of euros. Based on the new strategy, will Erie Co. be subject to economic exposure to exchange rate risk in the future? Brieﬂy explain. 20. Using Regression Analysis to Measure Exposure.

second subperiod than in the ﬁrst subperiod. What does this tell you about the ﬁrm’s degree of economic exposure over time? Why might such results occur? 21. Transaction Exposure. Vegas Corp. is a U.S. ﬁrm that exports most of its products to Canada. It historically invoiced its products in Canadian dollars to accommodate the importers. However, it was adversely affected when the Canadian dollar weakened against the U.S. dollar. Since Vegas did not hedge, its Canadian dollar receivables were converted into a relatively small amount of U.S. dollars. After a few more years of continual concern about possible exchange rate movements, Vegas called its customers and requested that they pay for future orders with U.S. dollars instead of Canadian dollars. At this time, the Canadian dollar was valued at $.81. The customers decided to oblige since the number of Canadian dollars to be converted into U.S. dollars when importing the goods from Vegas was still slightly smaller than the number of Canadian dollars that would be needed to buy the product from a Canadian manufacturer. Based on this situation, has transaction exposure changed for Vegas Corp.? Has economic exposure changed? Explain. 22. Measuring Economic Exposure. Using the following cost and revenue information shown for DeKalb, Inc., determine how the costs, revenue, and cash ﬂow items would be affected by three possible exchange rate scenarios for the New Zealand dollar (NZ$): (1) NZ$ $.50, (2) NZ$ $.55, and (3) NZ$ $.60. (Assume U.S. sales will be unaffected by the exchange rate.) Assume that NZ$ earnings will be remitted to the U.S. parent at the end of the period. Ignore possible tax effects.

Revenue and Cost Estimates: DeKalb, Inc. (in Millions of U.S. Dollars and New Zealand Dollars) U.S. Business Sales

New Zealand Business

$800

NZ$800

a. How can a U.S. company use regression analysis

Cost of materials

500

100

to assess its economic exposure to ﬂuctuations in the British pound?

Operating expenses

300

0

b. In using regression analysis to assess the sensi-

Interest expense

100

0

tivity of cash ﬂows to exchange rate movements, what is the purpose of breaking the database into subperiods?

Cash ﬂow

$100

NZ$700

c. Assume the regression coefﬁcient based on as-

sessing economic exposure was much higher in the

23. Changes in Economic Exposure. Walt Disney World built an amusement park in France that

Chapter 10: Measuring Exposure to Exchange Rate Fluctuations

opened in 1992. How do you think this project has affected Disney’s economic exposure to exchange rate movements? Think carefully before you give your ﬁnal answer. There is more than one way in which Disney’s cash ﬂows may be affected. Explain. 24. Lagged Effects of Exchange Rate Movements. Cornhusker Co. is an exporter of products to Singapore. It wants to know how its stock price is affected by changes in the Singapore dollar’s exchange rate. It believes that the impact may occur with a lag of one to three quarters. How could regression analysis be used to assess the impact? 25. Potential Effects if the United Kingdom Adopted the Euro. The United Kingdom still has its own currency, the pound. The pound’s interest rate has historically been higher than the euro’s interest rate. The United Kingdom has considered adopting the euro as its currency. There have been many arguments about whether it should do so. Use your knowledge and intuition to discuss the likely effects if the United Kingdom adopts the euro. For each of the 10 statements below, insert either increase or decrease in the ﬁrst blank and complete the statement by adding a clear, short explanation (perhaps one to three sentences) of why the United Kingdom’s adoption of the euro would have that effect. To help you narrow your focus, follow these guidelines. Assume that the pound is more volatile than the euro. Do not base your answer on whether the pound would have been stronger than the euro in the future. Also, do not base your answer on an unusual change in economic growth in the United Kingdom or in the euro zone if the euro is adopted. a. The economic exposure of British ﬁrms that are heavy exporters to the euro zone would because . b. The translation exposure of ﬁrms based in the euro zone that have British subsidiaries would because . c. The economic exposure of U.S. ﬁrms that conduct substantial business in the United Kingdom and have no other international business would because . d. The translation exposure of U.S. ﬁrms with British subsidiaries would because . e. The economic exposure of U.S. ﬁrms that export to the United Kingdom and whose only other international business is importing from ﬁrms based in the euro zone would because .

301

f. The discount on the forward rate paid by U.S.

ﬁrms that periodically use the forward market to hedge payables of British imports would because . g. The earnings of a foreign exchange department

of a British bank that executes foreign exchange transactions desired by its European clients would because . h. Assume that the Swiss franc is more highly cor-

related with the British pound than with the euro. A U.S. ﬁrm has substantial monthly exports to the United Kingdom denominated in the British currency and also has substantial monthly imports of Swiss supplies (denominated in Swiss francs). The economic exposure of this ﬁrm would because . i. Assume that the Swiss franc is more highly cor-

related with the British pound than with the euro. A U.S. ﬁrm has substantial monthly exports to the United Kingdom denominated in the British currency and also has substantial monthly exports to Switzerland (denominated in Swiss francs). The economic exposure of this ﬁrm would because . j. The British government’s reliance on monetary

policy (as opposed to ﬁscal policy) as a means of ﬁne-tuning the economy would because . 26. Invoicing Policy to Reduce Exposure. Celtic Co. is a U.S. ﬁrm that exports its products to England. It faces competition from many ﬁrms in England. Its price to customers in England has generally been lower than those of the competitors, primarily because the British pound has been strong. It has priced its exports in pounds and then converts the pound receivables into dollars. All of its expenses are in the United States and are paid with dollars. It is concerned about its economic exposure. It considers a change in its pricing policy, in which it will price its products in dollars instead of pounds. Offer your opinion on why this will or will not signiﬁcantly reduce its economic exposure. 27. Exposure of an MNC’s Subsidiary. Decko Co. is a U.S. ﬁrm with a Chinese subsidiary that produces cell phones in China and sells them in Japan. This subsidiary pays its wages and its rent in Chinese yuan. The cell phones sold to Japan are denominated in Japanese yen. Assume that Decko Co. expects that the Chinese yuan will continue to remain stable against the U.S. dollar. The subsidiary’s main goal is to generate proﬁts for itself and it reinvests the proﬁts. It does not plan to remit any funds to the U.S. parent.

302

Part 3: Exchange Rate Risk Management a. Assume that the Japanese yen strengthens

against the U.S. dollar over time. How would this be expected to affect the proﬁts earned by the Chinese subsidiary? b. If Decko Co. had established its subsidiary in

Tokyo, Japan, instead of China, would its subsidiary’s proﬁts be more exposed or less exposed to exchange rate risk? c. Why do you think that Decko Co. established

the subsidiary in China instead of Japan? Assume no major country risk barriers. d. If the Chinese subsidiary needs to borrow money

to ﬁnance its expansion and wants to reduce its exchange rate risk, should it borrow U.S. dollars, Chinese yuan, or Japanese yen? 28. Washington Co. and Vermont Co. have no domestic business. They have a similar dollar equivalent amount of international exporting business. Washington Co. exports all of its products to Canada. Vermont Co. exports its products to Poland and Mexico, with about half of its business in each of these two countries. Each ﬁ rm receives the currency of the country where it sends its exports. You obtain the end-of-month spot exchange rates of the currencies mentioned above during the end of each of the last 6 months.

End of Month

Canadian Dollar

Mexican Peso

Polish Zloty

1

$.8142

$.09334

$.29914

2

.8176

.09437

.29829

3

.8395

.09241

.30187

4

.8542

.09263

.3088

5

.8501

.09251

.30274

6

.8556

.09448

.30312

You want to assess the data in a logical manner to determine which ﬁ rm has a higher degree of exchange rate risk. Show your work and write your conclusion. 29. Exposure to Pegged Currency System. Assume that the Mexican peso and the Brazilian currency (the real) have depreciated against the U.S. dollar recently due to the high inﬂation rates in those countries. Assume that inﬂation in these two countries is expected to continue and that it will have a major effect on these currencies if they are still allowed to ﬂoat. Assume that the government of Brazil decides to peg its currency to the dollar and will deﬁ nitely

maintain the peg for the next year. Milez Co. is based in Mexico. Its main business is to export supplies from Mexico to Brazil. It invoices its supplies in Mexican pesos. Its main competition is from ﬁ rms in Brazil that produce similar supplies and sell them locally. How will the sales volume of Milez Co. be affected (if at all) by the Brazilian government’s actions? Explain. 30. Assessing Currency Volatility. Zemart is a U.S. ﬁ rm that plans to establish international business in which it will export to Mexico (these exports will be denominated in pesos) and to Canada (these exports will be denominated in Canadian dollars) once a month and will therefore receive payments once a month. It is concerned about exchange rate risk. It wants to compare the standard deviation of exchange rate movements of these two currencies against the U.S. dollar on a monthly basis. For this reason, it asks you to: a. Estimate the standard deviation of the monthly movements in the Canadian dollar against the U.S. dollar over the last 12 months. b. Estimate the standard deviation of the monthly movements in the Mexican peso against the U.S. dollar over the last 12 months. c. Determine which currency is less volatile.

You can use the oanda.com website (or any legitimate website that has currency data) to obtain the end-of-month direct exchange rate of the peso and the Canadian dollar in order to do your analysis. Show your work. You can use a calculator or a spreadsheet (like Excel) to do the actual computations. 31. Exposure of Net Cash Flows. Each of the following U.S. ﬁ rms is expected to generate $40 million in net cash ﬂows (after including the estimated cash ﬂows from international sales if there are any) over the next year. Ignore any tax effects. Each ﬁ rm has the same level of expected earnings. None of the ﬁ rms has taken any position in exchange rate derivatives to hedge exchange rate risk. All payments for the international trade by each ﬁ rm will occur one year from today. Sunrise Co. has ordered imports from Austria, and its imports are invoiced in euros. The dollar value of the payables (based on today’s exchange rate) from its imports during this year is $10 million. It has no international sales. Copans Co. has ordered imports from Mexico, and its imports are invoiced in U.S. dollars. The dollar value of the payables from its imports during this year is $15 million. It has no international sales.

Chapter 10: Measuring Exposure to Exchange Rate Fluctuations

Yamato Co. ordered imports from Italy, and its imports are invoiced in euros. The dollar value of the payables (based on today’s exchange rate) from its imports during this year is $12 million. In addition, Yamato exports to Portugal, and its exports are denominated in euros. The dollar value of the receivables (based on today’s exchange rate) from its exports during this year is $8 million. Glades Co. ordered imports from Belgium, and these imports are invoiced in euros. The dollar value of the payables (based on today’s exchange rate) from its imports during this year is $7 million. Glades also ordered imports from Luxembourg, and these imports are denominated in dollars. The dollar value of these payables is $30 million. Glades has no international sales. Based on this information, which ﬁ rm is exposed to the most exchange rate risk? Explain. 32. Cash Flow Sensitivity to Exchange Rate Movements. The Central Bank of Poland is about to engage in indirect intervention later today in which it will lower Poland’s interest rates substantially. This will have an impact on the value of the Polish currency (zloty) against most currencies because it will immediately affect capital ﬂows. Missouri Co. has a subsidiary in Poland that sells appliances. The demand for its appliances is not affected much by the local economy. Most of its appliances produced in Poland are typically invoiced in zloty and are purchased by consumers from Germany. The subsidiary’s main competition is from appliance producers in Portugal, Spain, and Italy, which also export appliances to Germany. a. Explain how the impact on the zloty’s value will affect the sales of appliances by the Polish subsidiary. b. The subsidiary owes a British company 1 million British pounds for some technology that the British company provided. Explain how the impact on the zloty’s value will affect the cost of this technology to the subsidiary. c. The subsidiary plans to take 2 million zloty from its recent earnings and will remit it to the U.S. parent in the near future. Explain how the impact on the zloty’s value will affect the amount of dollar cash ﬂows received by the U.S. parent due to this remittance of earnings by the subsidiary.

33. Applying the Value-at-Risk Method. You use today’s spot rate of the Brazilian real to forecast the spot rate of the real for one month ahead. Today’s spot rate is $.4558. Use the value-at-risk method to determine the maximum percentage loss of the

303

Brazilian real over the next month based on a 95 percent conﬁdence level. Use the spot exchange rates at the end of each of the last 6 months to conduct your analysis. Forecast the exchange rate that would exist under these conditions. 34. Assessing Translation Exposure. Kanab Co. and Zion Co. are U.S. companies that engage in much business within the United States and are about the same size. They both conduct some international business as well. Kanab Co. has a subsidiary in Canada that will generate earnings of about C$20 million in each of the next 5 years. Kanab Co. also has a U.S. business that will receive about C$1 million (after costs) in each of the next 5 years as a result of exporting products to Canada that are denominated in Canadian dollars. Zion Co. has a subsidiary in Mexico that will generate earnings of about 1 million pesos in each of the next 5 years. Zion Co. also has a business in the United States that will receive about 300 million pesos (after costs) in each of the next 5 years as a result of exporting products to Mexico that are denominated in Mexican pesos. The salvage value of Kanab’s Canadian subsidiary and Zion’s Mexican subsidiary will be zero in 5 years. The spot rate of the Canadian dollar is $.60 while the spot rate of the Mexican peso is $.10. Assume the Canadian dollar could appreciate or depreciate against the U.S. dollar by about 8 percent in any given year, while the Mexican peso could appreciate or depreciate against the U.S. dollar by about 12 percent in any given year. Which company is subject to a higher degree of translation exposure? Explain. 35. Cross-Currency Relationships. The Hong Kong dollar (HK$) is presently pegged to the U.S. dollar and is expected to remain pegged. Some Hong Kong ﬁ rms export products to Australia that are denominated in Australian dollars and have no other business in Australia. The exports are not hedged. The Australian dollar is presently worth .50 U.S. dollars, but you expect that it will be worth .45 U.S. dollars by the end of the year. Based on your expectations, will the Hong Kong exporters be affected favorably or unfavorably? Brieﬂy explain. 36. Interpreting Economic Exposure. Spratt Co. (a U.S. ﬁ rm) attempts to determine its economic exposure to movements in the British pound by applying regression analysis to data over the last 36 quarters:

SP b 0 b 1e m

304

Part 3: Exchange Rate Risk Management

where SP represents the percentage change in Spratt’s stock price per quarter, e represents the percentage change in the pound value per quarter, and m is an error term. Based on the analysis, the b 0 coefﬁcient is zero and the b 1 coefﬁcient is .4 and is statistically signiﬁcant. Assume that interest rate parity exists. Today, the spot rate of the pound is $1.80, the 90-day British interest rate is 3 percent, and the 90-day U.S. interest rate is 2 percent. Assume that the 90-day forward rate is expected to be an accurate forecast of the future spot rate. Would you expect that Spratt’s value will be favorably

BLADES,

INC.

affected, unfavorably affected, or not affected by its economic exposure over the next quarter? Explain. Discussion in the Boardroom This exercise can be found in Appendix E at the back of this textbook. Running Your Own MNC This exercise can be found on the Xtra! website at http://maduraxtra.swlearning.com.

CASE

Assessment of Exchange Rate Exposure Blades, Inc., is currently exporting roller blades to Thailand and importing certain components needed to manufacture roller blades from that country. Under a ﬁxed contractual agreement, Blades’ primary customer in Thailand has committed itself to purchase 180,000 pairs of roller blades annually at a ﬁxed price of 4,594 Thai baht (THB) per pair. Blades is importing rubber and plastic components from various suppliers in Thailand at a cost of approximately THB2,871 per pair, although the exact price (in baht) depends on current market prices. Blades imports materials sufﬁcient to manufacture 72,000 pairs of roller blades from Thailand each year. The decision to import materials from Thailand was reached because rubber and plastic components needed to manufacture Blades’ products are inexpensive, yet of high quality, in Thailand. Blades has also conducted business with a Japanese supplier in the past. Although Blades’ analysis indicates that the Japanese components are of a lower quality than the Thai components, Blades has occasionally imported components from Japan when the prices were low enough. Currently, Ben Holt, Blades’ chief ﬁnancial ofﬁcer (CFO), is considering importing components from Japan more frequently. Speciﬁcally, he would like to reduce Blades’ baht exposure by taking advantage of the recently high correlation between the baht and the yen. Since Blades has net inﬂows denominated in baht and would have outﬂows denominated in yen, its net transaction exposure would be reduced if these two currencies were highly correlated. If Blades decides to import components from Japan, it would probably import materials sufﬁcient to manufacture 1,700 pairs of roller blades annually at a price of ¥7,440 per pair.

Holt is also contemplating further expansion into foreign countries. Although he would eventually like to establish a subsidiary or acquire an existing business overseas, his immediate focus is on increasing Blades’ foreign sales. Holt’s primary reason for this plan is that the proﬁt margin from Blades’ imports and exports exceeds 25 percent, while the proﬁt margin from Blades’ domestic production is below 15 percent. Consequently, he believes that further foreign expansion will be beneﬁcial to the company’s future. Though Blades’ current exporting and importing practices have been proﬁtable, Ben Holt is contemplating extending Blades’ trade relationships to countries in different regions of the world. One reason for this decision is that various Thai roller blade manufacturers have recently established subsidiaries in the United States. Furthermore, various Thai roller blade manufacturers have recently targeted the U.S. market by advertising their products over the Internet. As a result of this increased competition from Thailand, Blades is uncertain whether its primary customer in Thailand will renew the current commitment to purchase a ﬁxed number of roller blades annually. The current agreement will terminate in 2 years. Another reason for engaging in transactions with other, non-Asian, countries is that the Thai baht has depreciated substantially recently, which has somewhat reduced Blades’ proﬁt margins. The sale of roller blades to other countries with more stable currencies may increase Blades’ proﬁt margins. While Blades will continue exporting to Thailand under the current agreement for the next 2 years, it may also export roller blades to Jogs, Ltd., a British retailer. Preliminary negotiations indicate that Jogs

Chapter 10: Measuring Exposure to Exchange Rate Fluctuations

would be willing to commit itself to purchase 200,000 pairs of “Speedos,” Blades’ primary product, for a ﬁxed price of £80 per pair. Holt is aware that further expansion would increase Blades’ exposure to exchange rate ﬂuctuations, but he believes that Blades can supplement its proﬁt margins by expanding. He is vaguely familiar with the different types of exchange rate exposure but has asked you, a ﬁnancial analyst at Blades, Inc., to help him assess how the contemplated changes would affect Blades’ ﬁnancial position. Among other concerns, Holt is aware that recent economic problems in Thailand have had an effect on Thailand and other Asian countries. Whereas the correlation between Asian currencies such as the Japanese yen and the Thai baht is generally not very high and very unstable, these recent problems have increased the correlation among most Asian currencies. Conversely, the correlation between the British pound and the Asian currencies is quite low. To aid you in your analysis, Holt has provided you with the following data:

Currency

Expected Exchange Rate

British pound

$1.50

$1.47 to $1.53

Japanese yen

$ .0083

$.0079 to $.0087

Thai baht

$ .024

$.020 to $.028

SMALL

Range of Possible Exchange Rates

BUSINESS

305

Holt has asked you to answer the following questions: 1. What type(s) of exposure (i.e., transaction, economic, or translation exposure) is Blades subject to? Why? 2. Using a spreadsheet, conduct a consolidated net cash ﬂow assessment of Blades, Inc., and estimate the range of net inﬂows and outﬂows for Blades for the coming year. Assume that Blades enters into the agreement with Jogs, Ltd. 3. If Blades does not enter into the agreement with the British ﬁrm and continues to export to Thailand and import from Thailand and Japan, do you think the increased correlations between the Japanese yen and the Thai baht will increase or reduce Blades’ transaction exposure? 4. Do you think Blades should import components from Japan to reduce its net transaction exposure in the long run? Why or why not? 5. Assuming Blades enters into the agreement with Jogs, Ltd., how will its overall transaction exposure be affected? 6. Given that Thai roller blade manufacturers located in Thailand have begun targeting the U.S. roller blade market, how do you think Blades’ U.S. sales were affected by the depreciation of the Thai baht? How do you think its exports to Thailand and its imports from Thailand and Japan were affected by the depreciation?

DILEMMA

Assessment of Exchange Rate Exposure by the Sports Exports Company At the current time, the Sports Exports Company is willing to receive payments in British pounds for the monthly exports it sends to the United Kingdom. While all of its receivables are denominated in pounds, it has no payables in pounds or in any other foreign currency. Jim Logan, owner of the Sports Exports Company, wants to assess his ﬁrm’s exposure to exchange rate risk. 1. Would you describe the exposure of the Sports Exports Company to exchange rate risk as transaction exposure? Economic exposure? Translation exposure? 2. Jim Logan is considering a change in the pricing policy in which the importer must pay in dollars,

so that Jim will not have to worry about converting pounds to dollars every month. If implemented, would this policy eliminate the transaction exposure of the Sports Exports Company? Would it eliminate Sports Exports’ economic exposure? Explain. 3. If Jim decides to implement the policy described in the previous question, how would the Sports Exports Company be affected (if at all) by appreciation of the pound? By depreciation of the pound? Would these effects on Sports Exports differ if Jim retained his original policy of pricing the exports in British pounds?

306

Part 3: Exchange Rate Risk Management

I N T E R N E T/ E XC E L 1. Go to http://www.oanda.com/convert/fxhistory and obtain the direct exchange rate of the Canadian dollar and euro at the beginning of each of the last 7 years. a. Assume you received C$2 million in earnings

from your Canadian subsidiary at the beginning of each year over the last 7 years. Multiply this amount times the direct exchange rate of the Canadian dollar at the beginning of each year to determine how many U.S. dollars you received. Determine the percentage change in the dollar cash ﬂows received from one year to the next. Determine the standard deviation of these percentage changes. This measures the volatility of movements in the dollar earnings resulting from your Canadian business over time. b. Now assume that you also received 1 million

euros at the beginning of each year from your German subsidiary. Repeat the same process for the euro to measure the volatility of movements in the dollar cash ﬂows resulting from your German business over time. Are the movements in dollar cash ﬂows more volatile for the Canadian business or the German business? c. Now consider the dollar cash ﬂows you received

from the Canadian subsidiary and the German

EXERCISES subsidiary combined. That is, add the dollar cash ﬂows received from both businesses for each year. Repeat the process to measure the volatility of movements in the dollar cash ﬂows resulting from both businesses over time. Compare the volatility in the dollar cash ﬂows of the portfolio to the volatility in cash ﬂows resulting from the German business. Does it appear that diversiﬁcation of businesses across two countries results in more stable cash ﬂows than the business in Germany? Explain. d. Compare the volatility in the dollar cash ﬂows of the portfolio to the volatility in cash ﬂows resulting from the Canadian business. Does it appear that diversiﬁcation of businesses across two countries results in more stable cash ﬂow movements than the business in Canada? Explain.

2. The following website contains annual reports of many MNCs: http://www.reportgallery.com. Review the annual report of your choice. Look for any comments in the report that describe the MNC’s transaction exposure, economic exposure, or translation exposure. Summarize the MNC’s exposure based on the comments in the annual report.

11: Managing Transaction Exposure Recall from the previous chapter that a multinational corporation (MNC) is exposed to exchange rate ﬂuctuations in three ways: (1) transaction exposure, (2) economic exposure, and (3) translation exposure. This chapter focuses on the management of transaction exposure, while the following chapter focuses on the management of economic and translation exposure. By managing transaction exposure, ﬁnancial managers may be able to increase cash ﬂows and enhance the value of their MNCs.

The specific objectives of this chapter are to: ■ compare the techniques commonly used to hedge

payables, ■ compare the techniques commonly used to hedge

receivables, ■ explain how to hedge long-term transaction exposure,

and ■ suggest other methods of reducing exchange rate risk

when hedging techniques are not available.

Transaction Exposure Transaction exposure exists when the anticipated future cash transactions of a ﬁ rm are affected by exchange rate ﬂuctuations. A U.S. ﬁ rm that purchases Mexican goods may need pesos to buy the goods. Though it may know exactly how many pesos it will need, it doesn’t know how many dollars will be needed to be exchanged for those pesos. This uncertainty occurs because the exchange rate between pesos and dollars ﬂuctuates over time. A U.S.-based MNC that will be receiving a foreign currency is exposed because it does not know how many dollars it will obtain when it exchanges the foreign currency for dollars. If transaction exposure exists, the ﬁ rm faces three major tasks. First, it must identify its degree of transaction exposure. Second, it must decide whether to hedge this exposure. Finally, if it decides to hedge part or all of the exposure, it must choose among the various hedging techniques available. Each of these tasks is discussed in turn.

Identifying Net Transaction Exposure Before an MNC makes any decisions related to hedging, it should identify the individual net transaction exposure on a currency-by-currency basis. The term net here refers to the consolidation of all expected inﬂows and outﬂows for a particular time and currency. The management at each subsidiary plays a vital role in reporting its expected inﬂows and outﬂows. Then a centralized group consolidates the subsidiary reports to identify, for the MNC as a whole, the expected net positions in each foreign currency during several upcoming periods. The MNC can identify its exposure by reviewing this consolidation of subsidiary positions. For example, one subsidiary may have net receivables in Mexican pesos 3 months from now, while a different subsidiary has net payables in pesos. If the peso appreciates, this will be favorable to the ﬁ rst subsidiary and unfavorable to the second

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subsidiary. For the MNC as a whole, however, the impact is at least partially offset. Each subsidiary may desire to hedge its net currency position in order to avoid the possible adverse impacts on its performance due to ﬂuctuation in the currency’s value. The overall performance of the MNC, however, may already be insulated by the offsetting positions between subsidiaries. Therefore, hedging the position of each individual subsidiary may not be necessary. Eastman Kodak Co. uses a centralized currency management approach to manage its transaction exposure. Kodak bills its subsidiaries in their local currencies. The rationale behind this strategy is to shift the foreign exchange exposure from the subsidiaries to the parent company. The parent receives foreign currencies from its subsidiaries overseas and converts them to U.S. dollars. It can maintain the currencies as foreign deposits if it believes the currencies will strengthen against the U.S. dollar in the near future. ■

E X A M P L E

Adjusting the Invoice Policy to Manage Exposure In some circumstances, the U.S. ﬁ rm may be able to modify its pricing policy to hedge against transaction exposure. That is, the ﬁ rm may be able to invoice (price) its exports in the same currency that will be needed to pay for imports. Stovall, Inc., has continual payables in Mexican pesos because a Mexican exporter sends goods to Stovall under the condition that the goods be invoiced in Mexican pesos. Stovall also exports products (invoiced in U.S. dollars) to other corporations in Mexico. If Stovall changes its invoicing policy from U.S. dollars to pesos, it can use the peso receivables from its exports to pay off its future payables in pesos. It is unlikely, however, that Stovall would be able to (1) invoice the precise amount of peso receivables to match the peso payables and (2) perfectly time the inflows and outflows to match each other. ■

E X A M P L E

Because the matching of inﬂows and outﬂows in foreign currencies does have its limitations, an MNC will normally be exposed to some degree of exchange rate risk and, therefore, should consider the various hedging techniques identiﬁed next. Aligning Manager Compensation with Hedging Goals If managers of a subsidiary are compensated according to the subsidiary’s earnings, the managers will want to hedge some currency positions that could adversely affect their earnings. For an MNC with many subsidiaries, some currency positions at subsidiaries will offset each other, so that a hedge by one subsidiary could actually increase the MNC’s overall exposure. An MNC can use a centralized system for assessing and hedging exposure to ensure that its subsidiaries do not hedge. However, this system can affect the cash flows and performance of each subsidiary and, therefore, may affect the compensation to the managers of each subsidiary. The MNC’s parent can implement a compensation system that does not penalize the managers of subsidiaries if their cash flows are reduced due to adverse currency movements. ■

GOVE ER RN NA AN NC CE E

Hedging Exposure to Payables An MNC may decide to hedge part or all of its known payables transactions so that it is insulated from possible appreciation of the currency. It may select from the following hedging techniques to hedge its payables: • Futures hedge • Forward hedge • Money market hedge • Currency option hedge

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Before selecting a hedging technique, MNCs normally compare the cash ﬂows that would be expected from each technique. The proper hedging technique can vary over time, as the relative advantages of the various techniques may change over time. Each technique is discussed in turn, with examples provided. The techniques can be compared to determine the appropriate technique to hedge a particular position.

Forward or Futures Hedge on Payables Forward contracts and futures contracts allow an MNC to lock in a speciﬁc exchange rate at which it can purchase a speciﬁc currency and, therefore, allow it to hedge payables denominated in a foreign currency. A forward contract is negotiated between the ﬁ rm and a ﬁ nancial institution such as a commercial bank and, therefore, can be tailored to meet the speciﬁc needs of the ﬁ rm. The contract will specify the: • currency that the ﬁ rm will pay • currency that the ﬁ rm will receive • amount of currency to be received by the ﬁ rm • rate at which the MNC will exchange currencies (called the forward rate) • future date at which the exchange of currencies will occur Coleman Co. is a U.S.-based MNC that will need 100,000 euros in one year. It could obtain a forward contract to purchase the euros in one year. The one-year forward rate is $1.20, the same rate as currency futures contracts on euros. If Coleman purchases euros one year forward, its dollar cost in one year is:

E X A M P L E

Cost in $ 5 Payables 3 Forward rate 5 100,000 euros 3 $1.20 5 $120,000

H T T P : // http://www .bmonesbittburns.com/ economics/fxrates Forward rates for the euro, British pound, Canadian dollar, and Japanese yen for 1-month, 3-month, 6-month, and 12-month maturities. These forward rates indicate the exchange rates at which positions in these currencies can be hedged for speciﬁc time periods.

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The same process would apply if futures contracts were used instead of forward contracts. The futures rate is normally very similar to the forward rate, so the main difference would be that the futures contracts are standardized and would be purchased on an exchange, while the forward contract would be negotiated between the MNC and a commercial bank. Forward contracts are commonly used by large corporations that desire to hedge. For example, DuPont Co. often has the equivalent of $300 million to $500 million in forward contracts at any one time to cover open currency positions, while Union Carbide has more than $100 million in forward contracts.

Money Market Hedge on Payables A money market hedge involves taking a money market position to cover a future payables or receivables position. If a ﬁ rm has excess cash, it can create a simpliﬁed money market hedge. Recall that Coleman Co. needs 100,000 euros in one year. If it has cash, it could convert dollars into euros and deposit them in a bank for one year. Assuming that it could earn 5 percent on this deposit, it would need to deposit euros today, as shown here:

E X A M P L E

Deposit amount to hedge payables 5

100,000 euros 5 95,238 euros 1 1 .05

Assuming a spot rate today of $1.18, the dollars needed to make the deposit today are estimated below:

Deposit amount in dollars 95,238 euros $1.18 $112,381

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In many cases, MNCs prefer to hedge payables without using their cash balances. A money market hedge can still be used in this situation, but it requires two money market positions: (1) borrowed funds in the home currency and (2) a short-term investment in the foreign currency. If Coleman Co. did not have cash available, it could borrow the funds that it needs. Assuming that Coleman can borrow dollars at an interest rate of 8 percent, it would borrow the funds needed to make the deposit, and at the end of the year it would repay the loan:

E X A M P L E

Dollar amount of loan repayment $112,381 (1 .08) $121,371

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Hedging with a Money Market Hedge versus a Forward Hedge. Should an MNC implement a forward contract hedge or a money market hedge? Since the results of both hedges are known beforehand, the ﬁ rm can implement the one that is more feasible. If interest rate parity (IRP) exists, and transaction costs do not exist, the money market hedge will yield the same results as the forward hedge. This is so because the forward premium on the forward rate reﬂects the interest rate differential between the two currencies. The hedging of future payables with a forward purchase will be similar to borrowing at the home interest rate and investing at the foreign interest rate. The hedging of future receivables with a forward sale is similar to borrowing at the foreign interest rate and investing at the home interest rate. Even if the forward premium generally reﬂects the interest rate differential between countries, the existence of transaction costs may cause the results from a forward hedge to differ from those of the money market hedge.

Call Option Hedge Firms recognize that hedging techniques such as the forward hedge and money market hedge can backﬁ re when a payables currency depreciates or a receivables currency appreciates over the hedged period. In these situations, an unhedged strategy would likely outperform the forward hedge or money market hedge. The ideal hedge would insulate the ﬁ rm from adverse exchange rate movements but allow the ﬁ rm to beneﬁt from favorable exchange rate movements. Currency options exhibit these attributes. However, a ﬁ rm must assess whether the advantages of a currency option hedge are worth the price (premium) paid for it. Details on currency options are provided in Chapter 5. The following discussion illustrates how they can be used in hedging.

Hedging Payables with Currency Call Options. A currency

H T T P : // http://www.phlx.com/ products/currency/currency .html Provides various currency option contracts that can be used to hedge positions.

call option provides the right to buy a speciﬁed amount of a particular currency at a speciﬁed price (called the strike price, or exercise price) within a given period of time. Yet, unlike a futures or forward contract, the currency call option does not obligate its owner to buy the currency at that price. If the spot rate of the currency remains lower than the exercise price throughout the life of the option, the ﬁ rm can let the option expire and simply purchase the currency at the existing spot rate. On the other hand, if the spot rate of the currency appreciates over time, the call option allows the ﬁ rm to purchase the currency at the exercise price. That is, the ﬁ rm owning a call option has locked in a maximum price (the exercise price) to pay for the currency. Yet, it also has the ﬂexibility to let the option expire and obtain the currency at the existing spot rate when the currency is to be sent for payment.

Cost of Hedging with Call Options Based on a Contingency Graph. The cost of hedging with call options is not known with certainty at the time that the options are purchased. It is only known once the

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payables are due and the spot rate at that time is known. For this reason, an MNC attempts to determine what the cost of hedging with call options would be based on various possible spot rates that could exist for the foreign currency at the time that payables are due. This cost of hedging includes the price paid for the currency, along with the premium paid for the call option. If the spot rate of the currency at the time payables are due is less than the exercise price, the MNC would let the option expire because it could purchase the currency in the foreign exchange market at the spot rate. If the spot rate is equal to or above the exercise price, the MNC would exercise the option and pay the exercise price for the currency. An MNC can develop a contingency graph that determines the cost of hedging with call options for each of several possible spot rates when payables are due. It may be especially useful when a MNC would like to assess the cost of hedging for a wide range of possible spot rate outcomes. Recall that Coleman Co. considers hedging its payables of 100,000 euros in one year. It could purchase call options on 100,000 euros so that it can hedge its payables. Assume that the call options have an exercise price of $1.20, a premium of $.03, and an expiration date of one year from now (when the payables are due). Coleman can create a contingency graph for the call option hedge, as shown in Exhibit 11.1. The horizontal axis shows several possible spot rates of the euro that could occur at the time payables are due, while the vertical axis shows the cost of hedging per euro for each of those possible spot rates. At any spot rate less than the exercise price of $1.20, Coleman would not exercise the call option, so the cost of hedging would be equal to the spot rate at that time, along with the premium. For example, if the spot rate was $1.16 at the time payables were due, Coleman would pay that spot rate along with the $.03 premium per unit. At any spot rate more than or equal to the exercise price of $1.20, Coleman would exercise the call option, and the cost of hedging would be equal to the price paid per euro ($1.20) along with the premium of $.03 per euro. Thus, the cost of hedging is $1.23 for all spot rates beyond the exercise price of $1.20. ■

E E X X A M P L E

Cost of Hedging (Includes Price Paid per Euro Plus Option Premium)

Exhibit 11.1

Contingency Graph for Hedging Payables with Call Options

Excercise Price = $1.20 Premium = $.03 $1.23

$1.15

$1.15

$1.20

$1.25

$1.30

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Exhibit 11.1 illustrates the advantages and disadvantages of a call option for hedging payables. The advantage is that the call option provides an effective hedge, while also allowing the MNC to let the option expire if the spot rate at the time payables are due is lower than the exercise price. However, the obvious disadvantage of the call option is that a premium must be paid for it. To compare a hedge with a call option to a hedge with a forward contract, recall from a previous example that Coleman Co. could purchase a forward contract on euros for $1.20, which would result in a cost of hedging of $1.20 per euro, regardless of what the spot rate is at the time payables are due because a forward contract, unlike a call option, creates an irrevocable obligation to execute. This could be reﬂected on the same contingency graph in Exhibit 11.1 as a horizontal line beginning at the $1.20 point on the vertical axis and extending straight across for all possible spot rates. In general, the forward rate would result in a lower cost of hedging than currency call options if the spot rate is relatively high at the time payables are due, while currency call options would result in a lower cost of hedging than the forward rate if the spot rate is relatively low at the time payables are due.

Cost of Hedging with Call Options Based on Currency Forecasts. While the contingency graph can determine the cost of hedging for various possible spot rates when payables are due, it does not consider an MNC’s currency forecasts. Thus, it does not necessarily lead the MNC to a clear decision about whether to hedge with currency options. An MNC may wish to incorporate its own forecasts of the spot rate at the time payables are due, so that it can more accurately estimate the cost of hedging with call options. Recall that Coleman Co. considers hedging its payables of 100,000 euros with a call option that has an exercise price of $1.20, a premium of $.03, and an expiration date of one year from now. Also assume that Coleman’s forecast for the spot rate of the euro at the time payables are due is as follows:

E X A M P L E

• $1.16 (20 percent probability) • $1.22 (70 percent probability) • $1.24 (10 percent probability) The effect of each of these scenarios on Coleman’s cost of payables is shown in Exhibit 11.2. Columns 1 and 2 simply identify the scenario to be analyzed. Column 3 shows the premium per unit paid on the option, which is the same regardless of the spot rate that occurs when payables are due. Column 4 shows the amount that Coleman would pay per euro for the payables under each scenario, assuming that it owned call options. If Scenario 1 occurs, Coleman will let the options expire and purchase euros in the spot market for $1.16 each. Exhibit 11.2

Use of Currency Call Options for Hedging Euro Payables (Exercise Price $1.20, Premium $.03) (3)

(4)

(5) (4) (3)

(6)

Scenario

Spot Rate When Payables Are Due

Premium per Unit Paid on Call Options

Amount Paid per Unit When Owning Call Options

Total Amount Paid per Unit (Including the Premium) When Owning Call Options

$ Amount Paid for 100,000 Euros When Owning Call Options

1

$1.16

$.03

$1.16

$1.19

$119,000

2

1.22

.03

1.20

1.23

123,000

3

1.24

.03

1.20

1.23

123,000

(1)

(2)

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If Scenario 2 or 3 occurs, Coleman will exercise the options and therefore purchase euros for $1.20 per unit, and it will use the euros to make its payment. Column 5, which is the sum of columns 3 and 4, shows the amount paid per unit when the $.03 premium paid on the call option is included. Column 6 converts column 5 into a total dollar cost, based on the 100,000 euros hedged. ■

Consideration of Alternative Call Options. Several different types of call options may be available, with different exercise prices and premiums for a given currency and expiration date. The tradeoff is that an MNC can obtain a call option with a lower exercise price but would have to pay a higher premium. Alternatively, it can select an option that has a lower premium but then must accept a higher exercise price. Whatever call option is perceived to be most desirable for hedging a particular payables position would be analyzed as explained in the example above, so that it could then be compared to the other hedging techniques.

Summary of Techniques Used to Hedge Payables The techniques that can be used to hedge payables are summarized in Exhibit 11.3, with an illustration of how the cost of each hedging technique was measured for Coleman Co. (based on the previous examples). Notice that the cost of the forward

Exhibit 11.3

Comparison of Hedging Alternatives for Coleman Co.

Forward Hedge Purchase euros 1 year forward. Dollars needed in 1 year payables in € forward rate of euro 100,000 euros $1.20 $120,000 Money Market Hedge Borrow $, convert to €, invest €, repay $ loan in 1 year. Amount in € to be invested €

100,000 1 .05

95,238 euros Amount in $ needed to convert into € for deposit €95,238 $1.18 $112,381 Interest and principal owed on $ loan after 1 year $112,381 (1 .08) $121,371 Call Option Purchase call option. (The following computations assume that the option is to be exercised on the day euros are needed, or not at all. Exercise price $1.20, premium $.03.)

Exercise Option?

Total Price (Including Option Premium) Paid per Unit

Total Price Paid for 100,000 Euros

Probability

$.03

No

$1.19

$119,000

20%

1.22

.03

Yes

1.23

123,000

70

1.24

.03

Yes

1.23

123,000

10

Possible Spot Rate in One Year

Premium per Unit Paid for Option

$1.16

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hedge or money market hedge can be determined with certainty, while the currency call option hedge has different outcomes depending on the future spot rate at the time payables are due.

Selecting the Optimal Technique for Hedging Payables An MNC can select the optimal technique for hedging payables by following these steps. First, since the futures and forward hedge are very similar, the MNC only needs to consider whichever one of these techniques it prefers. Second, when comparing the forward (or futures) hedge to the money market hedge, the MNC can easily determine which hedge is more desirable because the cost of each hedge can be determined with certainty. Once that comparison is completed, the MNC can assess the feasibility of the currency call option hedge. The distribution of the estimated cash outﬂows resulting from the currency call option hedge can be assessed by estimating its expected value and by determining the likelihood that the currency call option hedge will be less costly than an alternative hedging technique. Recall that Coleman Co. needs to hedge payables of 100,000 euros. Coleman’s costs of different hedging techniques can be compared to determine which technique is optimal for hedging the payables. Exhibit 11.4 provides a graphic comparison of the cost of hedging resulting from using different techniques (which were determined in the previous examples in this chapter). For Coleman, the forward hedge is preferable to the money market hedge because it results in a lower cost of hedging payables. The cost of the call option hedge is described by a probability distribution because it is dependent on the exchange rate at the time that payables are due. The expected value of the cost if using the currency call option hedge is:

E X A M P L E

Expected value of cost 5 1 $119,000 3 20% 2 1 1 $123,000 3 80% 2 5 $122,200 The probability of the future spot rate being $1.22 (70 percent) and probability of the future spot rate being $1.24 (10 percent) are combined in the calculation because they result in the same cost. The expected value of the cost when hedging with call options exceeds the cost of the forward rate hedge. When comparing the distribution of the cost of hedging with call options to the cost of the forward hedge, there is a 20 percent chance that the currency call option hedge will be cheaper than the forward hedge. There is an 80 percent chance that the currency call option hedge will be more expensive than the forward hedge. Overall, the forward hedge is the optimal hedge. ■

The optimal technique to hedge payables may vary over time depending on the prevailing forward rate, interest rates, call option premium, and the forecast of the future spot rate at the time payables are due.

Optimal Hedge versus No Hedge Even when an MNC knows what its future payables will be, it may decide not to hedge in some cases. It needs to determine the probability distribution of its cost of payables when not hedging as explained next. Coleman Co. has already determined that the forward rate is the optimal hedging technique if it decides to hedge its payables position. Now it wants to compare the forward hedge to no hedge.

E X A M P L E

Exhibit 11.4

Graphic Comparison of Techniques to Hedge Payables

Probability

100% 80%

Forward Hedge

60% 40% 20% 0% $120,000 $ to be paid in 1 year

Probability

100% 80%

Money Market Hedge

60% 40% 20% 0% $121,371 $ to be paid in 1 year

Probability

100% 80%

Currency Call Option Hedge

60% 40% 20% 0% $119,000

$123,000 $ to be paid in 1 year

Probability

100% 80%

No Hedge

60% 40% 20% 0% $116,000

$122,000 $ to be paid in 1 year

$124,000

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Part 3: Exchange Rate Risk Management Based on its expectations of the euro’s spot rate in one year (as described earlier), Coleman Co. can estimate its cost of payables when unhedged:

Possible Spot Rate of Euro in One Year

Dollar Payments When Not Hedging 100,000 Euros Possible Spot Rate

Probability

$1.16

$116,000

20%

$1.22

$122,000

70%

$1.24

$124,000

10%

This probability distribution of costs when not hedging is shown in the bottom graph of Exhibit 11.4 and can be compared to the cost of the forward hedge in that exhibit. The expected value of the payables when not hedging is estimated as:

Expected value of payables 5 1 $116,000 3 20% 2 1 1 $122,000 3 70% 2 1 1 $124,000 3 10% 2 5 $121,000 This expected value of the payables is $1,000 more than if Coleman uses a forward hedge. In addition, the probability distribution suggests an 80 percent probability that the cost of the payables when unhedged will exceed the cost of hedging with a forward contract. Therefore, Coleman decide to hedge its payables position with a forward contract. ■

Evaluating the Hedge Decision MNCs can evaluate hedging decisions that they made in the past by estimating the real cost of hedging payables, which is measured as: RCHp 5 Cost of hedging payables 2 Cost of payables if not hedged After the payables transaction has occurred, an MNC may assess the outcome of its decision to hedge. Recall that Coleman Co. decided to hedge its payables with a forward contract, resulting in a dollar cost of $120,000. Assume that on the day that it makes its payment (one year after it hedged its payables), the spot rate of the euro is $1.18. Notice that this spot rate is different from any of the three possible spot rates that Coleman Co. predicted. This is not unusual, as it is difficult to predict the spot rate, even when creating a distribution of possible outcomes. If Coleman Co. had not hedged, its cost of the payables would have been $118,000 (computed as 100,000 euros $1.18). Thus, Coleman’s real cost of hedging is:

E X A M P L E

RCHp 5 Cost of hedging payables 2 Cost of payables if not hedged 5 $120,000 2 $118,000 5 $2,000

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In this example, Coleman’s cost of hedging payables turned out to be $2,000 more than if it had not hedged. However, Coleman is not necessarily disappointed in its decision to hedge. That decision allowed it to know exactly how many dollars it would need to cover its payables position and insulated the payment from movements in the euro.

Hedging Exposure to Receivables An MNC may decide to hedge part or all of its receivables transactions denominated in foreign currencies so that it is insulated from the possible depreciation of those currencies. It can apply the same techniques available for hedging payables to hedge

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receivables. The manner by which each technique is applied to hedge receivables is slightly different from its application to hedge payables. The application of each hedging technique to receivables is discussed next.

Forward or Futures Hedge on Receivables Forward contracts and futures contracts allow an MNC to lock in a speciﬁc exchange rate at which it can sell a speciﬁc currency and, therefore, allow it to hedge receivables denominated in a foreign currency. Viner Co. is a U.S.-based MNC that will receive 200,000 Swiss francs in 6 months. It could obtain a forward contract to sell SF200,000 in 6 months. The 6-month forward rate is $.71, the same rate as currency futures contracts on Swiss francs. If Viner sells Swiss francs 6 months forward, it can estimate the amount of dollars to be received in 6 months:

E X A M P L E

Cash inflow in $ 5 Receivables 3 Forward rate 5 SF200,000 3 $.71 5 $142,000

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The same process would apply if futures contracts were used instead of forward contracts. The futures rate is normally very similar to the forward rate, so the main difference would be that the futures contracts are standardized and would be sold on an exchange, while the forward contract would be negotiated between the MNC and a commercial bank.

Money Market Hedge on Receivables A money market hedge on receivables involves borrowing the currency that will be received and using the receivables to pay off the loan. Recall that Viner Co. will receive SF200,000 in 6 months. Assume that it can borrow funds denominated in Swiss francs at a rate of 3 percent over a 6-month period. The amount that it should borrow so that it can use all of its receivables to repay the entire loan in 6 months is:

E X A M P L E

Amount to borrow 5 SF200,000/ 1 1 1 .03 2 5 SF194,175 If Viner Co. obtains a 6-month loan of SF194,175 from a bank, it will owe the bank SF200,000 in 6 months. It can use its receivables to repay the loan. The funds that it borrowed can be converted to dollars and used to support existing operations. ■

If the MNC does not need any short-term funds to support existing operations, it can still obtain a loan as explained above, convert the funds to dollars, and invest the dollars in the money market. If Viner Co. does not need any funds to support existing operations, it can convert the Swiss francs that it borrowed into dollars. Assume the spot exchange rate is presently $.70. When Viner Co. converts the Swiss francs, it will receive:

E X A M P L E

Amount of dollars received from loan 5 SF194,175 3 $.70 5 $135,922 Then the dollars can be invested in the money market. Assume that Viner Co. can earn 2 percent interest over a 6-month period. In 6 months, the investment will be worth:

$135,922 3 1 1.02 2 5 $138,640

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Part 3: Exchange Rate Risk Management Thus, if Viner Co. uses a money market hedge, its receivables will be worth $138,640 in 6 months. ■

Put Option Hedge A put option allows an MNC to sell a speciﬁc amount of currency at a speciﬁed exercise price by a speciﬁed expiration date. An MNC can purchase a put option on the currency denominating its receivables and lock in the minimum amount that it would receive when converting the receivables into its home currency. However, the put option differs from a forward or futures contract in that it is an option and not an obligation. If the currency denominating the receivables is higher than the exercise price at the time of expiration, the MNC can let the put option expire and can sell the currency in the foreign exchange market at the prevailing spot rate. The MNC must also consider the premium that it must pay for the put option.

Cost of Hedging with Put Options Based on a Contingency Graph. The cost of hedging with put options is not known with certainty at the time that they are purchased. It is only known once the receivables are due and the spot rate at that time is known. For this reason, an MNC attempts to determine the amount of cash it will receive from the put option hedge based on various possible spot rates at the time that receivables arrive. An estimate of the cash to be received from a put option hedge is the estimated cash received from selling the currency minus the premium paid for the put option. If the spot rate of the currency at the time receivables arrive is less than the exercise price, the MNC would exercise the option and receive the exercise price when selling the currency. If the spot rate at that time is equal to or above the exercise price, the MNC would let the option expire and would sell the currency at the spot rate in the foreign exchange market. An MNC can develop a contingency graph that determines the cash received from hedging with put options depending on each of several possible spot rates when receivables arrive. It may be especially useful when an MNC would like to estimate the cash received from hedging based on a wide range of possible spot rate outcomes. Recall that Viner Co. considers hedging its receivables of SF200,000 in 6 months. It could purchase put options on SF200,000, so that it can hedge its receivables. Assume that the put options have an exercise price of $.70, a premium of $.02, and an expiration date of 6 months from now (when the receivables arrive). Viner can create a contingency graph for the put option hedge, as shown in Exhibit 11.5. The horizontal axis shows several possible spot rates of the Swiss franc that could occur at the time receivables arrive, while the vertical axis shows the cash to be received from the put option hedge based on each of those possible spot rates. At any spot rate less than or equal to the exercise price of $.70, Viner would exercise the put option and would sell the Swiss francs at the exercise price of $.70. After subtracting the $.02 premium per unit, Viner would receive $.68 per unit from selling Swiss francs. At any spot rate more than the exercise price, Viner would let the put option expire and would sell the francs at the spot rate in the foreign exchange market. For example, if the spot rate was $.75 at the time receivables were due, Viner would sell the Swiss francs at that rate. It would receive $.73 after subtracting the $.02 premium per unit. ■

E X A M P L E

Exhibit 11.5 illustrates the advantages and disadvantages of a put option for hedging receivables. The advantage is that the put option provides an effective hedge, while also allowing the MNC to let the option expire if the spot rate at the time receivables arrive is higher than the exercise price.

Chapter 11: Managing Transaction Exposure

Cash Received (after Deducting Option Premium)

Exhibit 11.5

319

Contingency Graph for Hedging Receivables with Put Options

Excercise Price = $.70 Premium = $.02 $.80

$.75

$.70

$.65 $.65

$.70

$.75

$.80

However, the obvious disadvantage of the put option is that a premium must be paid for it. Recall from a previous example that Viner Co. could sell a forward contract on Swiss francs for $.71, which would allow it to receive $.71 per Swiss franc, regardless of what the spot rate is at the time receivables arrive. This could be reﬂected on the same contingency graph in Exhibit 11.5 as a horizontal line beginning at the $.71 point on the vertical axis and extending straight across for all possible spot rates. In general, the forward rate hedge would provide a larger amount of cash than the put option hedge if the spot rate is relatively low at the time Swiss francs are received, while currency put options would provide a larger amount of cash than the forward rate if the spot rate is relatively high at the time Swiss francs are received.

Cost of Hedging with Put Options Based on Currency Forecasts. While the contingency graph can determine the cash to be received from hedging based on various possible spot rates when receivables will arrive, it does not consider an MNC’s currency forecasts. Thus, it does not necessarily lead the MNC to a clear decision about whether to hedge receivables with currency put options. An MNC may wish to incorporate its own forecasts of the spot rate at the time receivables will arrive, so that it can more accurately estimate the dollar cash inﬂows to be received when hedging with put options. Viner Co. considers purchasing a put option contract on Swiss francs, with an exercise price of $.72 and a premium of $.02. It has developed the following probability distribution for the spot rate of the Swiss franc in 6 months:

E E X X A M P L E

• $.71 (30 percent probability) • $.74 (40 percent probability) • $.76 (30 percent probability)

320

Part 3: Exchange Rate Risk Management The expected dollar cash flows to be received from purchasing the put options on Swiss francs are shown in Exhibit 11.6. The second column discloses the possible spot rates that may occur in 6 months according to Viner’s expectations. The third column shows the option premium that is the same regardless of what happens to the spot rate in the future. The fourth column shows the amount to be received per unit as a result of owning the put options. If the spot rate is $.71 in the future (see the first row), the put option will be exercised at the exercise price of $.72. If the spot rate is more than $.72 in 6 months (as reflected in rows 2 and 3), Viner will not exercise the option, and it will sell the Swiss francs at the prevailing spot rate. Column 5 shows the cash received per unit, which adjusts the figures in column 4 by subtracting the premium paid per unit for the put option. Column 6 shows the amount of dollars to be received, which is equal to cash received per unit (shown in column 5) multiplied by the amount of units (200,000 Swiss francs). ■

Consideration of Alternative Put Options. Several different types of put options may be available, with different exercise prices and premiums for a given currency and expiration date. An MNC can obtain a put option with a higher exercise price, but the tradeoff is that it would have to pay a higher premium. Alternatively, it can select a put option that has a lower premium but then must accept a lower exercise price. Whatever put option is perceived to be most desirable for hedging a particular receivables position would be analyzed as explained in the example above, so that it could then be compared to the other hedging techniques.

Selecting the Optimal Technique for Hedging Receivables The techniques that can be used to hedge receivables are summarized in Ex hibit 11.7, with an illustration of how the cash inﬂow from each hedging technique was measured for Viner Co. (based on previous examples). The optimal technique to hedge receivables may vary over time depending on the speciﬁc quotations, such as the forward rate quoted on a forward contract, the interest rates quoted on a money market loan, and the premium quoted on a put option. The optimal technique for hedging a speciﬁc receivables position at a future point in time can be determined by comparing the cash to be received among the hedging techniques. First, since the futures and forward hedge are very similar, the MNC only needs to consider whichever one of these techniques it prefers. For our example,

Exhibit 11.6 (1)

Use of Currency Put Options for Hedging Swiss Franc Receivables (Exercise Price = $.72; Premium = $.02) (2)

(3)

(4)

(5) (4) (3)

(6)

Net Amount Received per Unit (after Accounting for Premium Paid)

Dollar Amount Received from Hedging SF200,000 Receivables with Put Options

Scenario

Spot Rate When Payment on Receivables Is Received

Premium per Unit on Put Options

Amount Received per Unit When Owning Put Options

1

$.71

$.02

$.72

$.70

$140,000

2

.74

.02

.74

.72

144,000

3

.76

.02

.76

.74

148,000

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321

the forward hedge will be considered. Second, when comparing the forward (or futures) hedge to the money market hedge, the MNC can easily determine which hedge is more desirable because the cash to be received from either hedge can be determined with certainty. Once that comparison is completed, the MNC can assess the feasibility of the currency put option hedge. Since the amount of cash to be received from the currency put option is dependent on the spot rate that exists when receivables arrive, this amount can best be described with a probability distribution. This probability distribution of cash to be received when hedging with put options can be assessed by estimating the expected value and determining the likelihood that the currency put option hedge will result in more cash than an alternative hedging technique. Viner Co. can compare the cash to be received as the result of applying different hedging techniques to hedge receivables of SF200,000 in order to determine the optimal technique. Exhibit 11.8 provides a graphic summary of the cash to be received from each hedging technique, based on the previous examples for Viner Co. In this example, the forward hedge is better than the money market hedge because it will generate more cash.

E X A M P L E

Exhibit 11.7

Comparison of Hedging Alternatives for Viner Co.

Forward Hedge Sell Swiss francs 6 months forward. Dollars to be received in 6 months receivables in SF forward rate of SF SF200,000 $.71 $142,000 Money Market Hedge Borrow SF, convert to $, invest $, use receivables to pay off loan in 6 months. Amount in SF borrowed

SF200,000 1 .03

SF194,175 $ received from converting SF SF194,175 $.70 per SF $135,922 $ accumulated after 6 months $135,922 (1 .02) $138,640 Put Option Hedge Purchase put option. (Assume the options are to be exercised on the day SF are to be received, or not at all. Exercise price $.72, premium $.02.)

Exercise Option?

Received per Unit (after Accounting for the Premium)

Total Dollars Received from Converting SF200,000

Probability

$.02

Yes

$.70

$140,000

30%

.74

.02

No

.72

144,000

40

.76

.02

No

.74

148,000

30

Possible Spot Rate in 6 Months

Premium per Unit Paid for Option

.71

Exhibit 11.8

Graph Comparison of Techniques to Hedge Receivables

Probability

100% Forward Hedge

80% 60% 40% 20% 0% $142,000 $ to be received in 6 months

Probability

100% Money Market Hedge

80% 60% 40% 20% 0% $138,640

$ to be received in 6 months

Probability

100% 80%

Currency Put Option Hedge

60% 40% 20% 0% $140,000 $144,000 $148,000 $ to be received in 6 months

Probability

100% 80%

No Hedge

60% 40% 20% 0% $142,000 $148,000 $152,000 $ to be received in 6 months

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The graph for the put option hedge shows that the cash to be received is dependent on the exchange rate at the time that receivables are due. The expected value of the cash to be received from the put option hedge is:

Expected value of cash to be received 5 1 $140,000 3 30% 2 1 1 $144,000 3 40% 2 1 1 $148,000 3 30% 2 5 $144,000 The expected value of the cash to be received when hedging with put options exceeds the cash amount that would be received from the forward rate hedge. ■

When comparing the distribution of cash to be received from the put option to the cash when using the forward hedge (see Exhibit 11.8), there is a 30 percent chance that the currency put option hedge will result in less cash than the forward hedge. There is a 70 percent chance that the put option hedge will result in more cash than the forward hedge. Viner decides that the put option hedge is the optimal hedge.

Optimal Hedge versus No Hedge Even when an MNC knows what its future receivables will be, it may decide not to hedge in some cases. It needs to determine the probability distribution of its revenue from receivables when not hedging as shown in the following example. Viner Co. has already determined that the put option hedge is the optimal technique for hedging its receivables position. Now it wants to compare the put option hedge to no hedge. Based on its expectations of the Swiss franc’s spot rate in one year (as described earlier), Viner Co. can estimate the cash to be received if it remains unhedged:

E X X A M P L E

Possible Spot Rate of Swiss Franc in One Year

Dollar Payments When Not Hedging SF200,000 Possible Spot Rate

Probability

$.71

$142,000

30%

$.74

$148,000

40%

$.76

$152,000

30%

The expected value of cash that Viner Co. will receive when not hedging is estimated as:

Expected value of cash to be received 5 1 $142,000 3 30% 2 1 1 $148,000 3 40% 2 1 1 $152,000 3 30% 2 5 $147,400 When comparing this expected value to the expected value of cash that Viner Co. would receive from its put option hedge ($144,000), Viner decides to remain unhedged. In this example, Viner’s decisions to remain unhedged creates a tradeoff in which it hopes to benefit from the appreciation of the Swiss franc against the U.S. dollar over the next 6 months but is susceptible to adverse effects if the franc depreciates. ■

Evaluating the Hedge Decision Once the receivables transaction has occurred, an MNC can assess its decision to hedge or not hedge.

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Part 3: Exchange Rate Risk Management Recall that Viner Co. decided not to hedge its receivables. Assume that 6 months later when the receivables arrive, the spot rate of the Swiss franc is $.75. Notice that this spot rate is different from any of the three possible spot rates that Viner Co. predicted. This is not unusual, as it is difficult to predict the spot rate, even when creating a distribution of possible outcomes. Since Viner did not hedge, it receives:

E X A M P L E

Cash received 5 Spot rate of SF 3 SF200,000 at time of receivables transaction 5 $.75 3 SF200,000 5 $150,000 Now consider what the results would have been if Viner Co. had hedged the receivables position. Recall that Viner would have used the put option hedge if it hedged. Given the spot rate of $.75 when the receivables arrived, Viner would not have exercised the put option. Thus, it would have exchanged the Swiss francs in the spot market for $.75 per unit, minus the $.02 premium per unit that it would have paid for the put option. Its cash received from the put option hedge would have been:

Cash received 5 $.73 3 SF200,000 5 $146,000

■

In this example, Viner’s decision to remain unhedged generated $4,000 more than if it had hedged its receivables. The difference of $4,000 is the premium that Viner would have paid to obtain put options. While Viner beneﬁted from remaining unhedged in this example, it recognizes the risk from not hedging.

Comparison of Hedging Techniques Each of the hedging techniques is brieﬂy summarized in Exhibit 11.9. When using a futures hedge, forward hedge, or money market hedge, the ﬁ rm can estimate the funds (denominated in its home currency) that it will need for future payables, or the funds that it will receive after converting foreign currency receivables. The outcome is certain. Thus, it can compare the costs or revenue and determine which of these hedging techniques is appropriate. In contrast, the cash ﬂow associated with the currency option hedge cannot be determined with certainty because the costs of purchasing payables and the revenue generated from receivables are not known ahead of time. Therefore, ﬁ rms need to forecast cash ﬂows from the option hedge based on possible exchange rate outcomes. A fee (premium) must be paid for the option, but the option offers ﬂexibility because it does not have to be exercised. Exhibit 11.9

Review of Techniques for Hedging Transaction Exposure

Hedging Technique

To Hedge Payables

To Hedge Receivables

1. Futures hedge

Purchase a currency futures contract (or contracts) representing the currency and amount related to the payables.

Sell a currency futures contract (or contracts) representing the currency and amount related to the receivables.

2. Forward hedge

Negotiate a forward contract to purchase the amount of foreign currency needed to cover the payables.

Negotiate a forward contract to sell the amount of foreign currency that will be received as a result of the receivables.

3. Money market hedge

Borrow local currency and convert to currency denominating payables. Invest these funds until they are needed to cover the payables.

Borrow the currency denominating the receivables, convert it to the local currency, and invest it. Then pay off the loan with cash inﬂows from the receivables.

4. Currency option hedge

Purchase a currency call option (or options) representing the currency and amount related to the payables.

Purchase a currency put option (or options) representing the currency and amount related to the receivables.

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325

Hedging Policies of MNCs In general, hedging policies vary with the MNC management’s degree of risk aversion. An MNC may choose to hedge most of its exposure, to hedge none of its exposure, or to selectively hedge.

Hedging Most of the Exposure. Some MNCs hedge most of their exposure so that their value is not highly inﬂuenced by exchange rates. MNCs that hedge most of their exposure do not necessarily expect that hedging will always be beneﬁcial. In fact, such MNCs may even use some hedges that will likely result in slightly worse outcomes than no hedges at all, just to avoid the possibility of a major adverse movement in exchange rates. They prefer to know what their future cash inﬂows or outﬂows in terms of their home currency will be in each period because this improves corporate planning. A hedge allows the ﬁ rm to know the future cash ﬂows (in terms of the home currency) that will result from any foreign transactions that have already been negotiated.

Hedging None of the Exposure. MNCs that are well diversiﬁed across many countries may consider not hedging their exposure. This strategy may be driven by the view that a diversiﬁed set of exposures will limit the actual impact that exchange rates will have on the MNC during any period.

H T T P : // http://www.ibm.com/us/ The websites of various MNCs provide ﬁnancial statements such as annual reports that disclose the use of ﬁnancial derivatives for the purpose of hedging interest rate risk and foreign exchange rate risk.

Selective Hedging. Many MNCs, such as Black & Decker, Eastman Kodak, and Merck choose to hedge only when they expect the currency to move in a direction that will make hedging feasible. Zenith hedges its imports of Japanese components only when it expects the yen to appreciate. Merck has worldwide sales of over $6 billion per year with substantial receivables denominated in foreign currencies as a result of exporting. Since Merck wants to capitalize on the possible appreciation of these foreign currencies (weakening of the dollar), it uses put options to hedge its receivables denominated in foreign currencies. If the dollar weakens, Merck lets the put options expire because the receivables are worth more at the prevailing spot rate. Meanwhile, the put options provide insurance in case the dollar strengthens. If Merck feels very conﬁdent that the dollar will strengthen, it uses forward or futures contracts instead of put options because it must pay a premium for the put options. The following quotations from annual reports illustrate the strategy of selective hedging: The purpose of the Company’s foreign currency hedging activities is to reduce the risk that the eventual dollar net cash inflows resulting from sales outside the U.S. will be adversely affected by exchange rates. —The Coca-Cola Co. Decisions regarding whether or not to hedge a given commitment are made on a case-by-case basis by taking into consideration the amount and duration of the exposure, market volatility, and economic trends. —DuPont Co. We selectively hedge the potential effect of the foreign currency fluctuations related to operating activities. —General Mills Co. Selective hedging implies that the MNC prefers to exercise some control over its exposure and makes decisions based on conditions that may affect the currency’s future value.

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Part 3: Exchange Rate Risk Management

Limitations of Hedging Although hedging transaction exposure can be effective, there are some limitations that deserve to be mentioned here.

Limitation of Hedging an Uncertain Amount Some international transactions involve an uncertain amount of goods ordered and therefore involve an uncertain transaction amount in a foreign currency. Consequently, an MNC may create a hedge for a larger number of units than it will acutally need, which causes the opposite form of exposure. Recall the previous example on hedging receivables, which assumed that Viner Co. will receive SF200,000 in 6 months. Now assume that the receivables amount could actually be much lower. If Viner uses the money market hedge on SF200,000 and the receivables amount to only SF120,000, it will have to make up the difference by purchasing SF80,000 in the spot market to achieve the SF200,000 needed to pay off the loan. If the Swiss franc appreciates over the 6-month period, Viner will need a large amount in dollars to obtain the SF80,000. ■

E X A M P L E

This example shows how overhedging (hedging a larger amount in a currency than the actual transaction amount) can adversely affect a ﬁ rm. A solution to avoid overhedging is to hedge only the minimum known amount in the future transaction. In our example, if the future receivables could be as low as SF120,000, Viner could hedge this amount. Under these conditions, however, the ﬁ rm may not have completely hedged its position. If the actual transaction amount turns out to be SF200,000 as expected, Viner will be only partially hedged and will need to sell the extra SF80,000 in the spot market. Alternatively, Viner may consider hedging the minimum level of receivables with a money market hedge and hedging the additional amount of receivables that may occur with a put option hedge. In this way, it is covered if the receivables exceed the minimum amount. It can let the put option expire if the receivables do not exceed the minimum, or if it is better off exchanging the additional Swiss francs received in the spot market. Firms commonly face this type of dilemma because the precise amount to be received in a foreign currency at the end of a period can be uncertain, especially for ﬁ rms heavily involved in exporting. Based on this example, it should be clear that most MNCs cannot completely hedge all of their transactions. Nevertheless, by hedging a portion of those transactions that affect them, they can reduce the sensitivity of their cash ﬂows to exchange rate movements.

Limitation of Repeated Short-Term Hedging The continual hedging of repeated transactions that are expected to occur in the near future has limited effectiveness over the long run. Winthrop Co. is a U.S. importer that specializes in importing particular CD players in one large shipment per year and then selling them to retail stores throughout the year. Assume that today’s exchange rate of the Japanese yen is $.005 and that the CD players are worth ¥60,000, or $300. The forward rate of the yen generally exhibits a premium of 2 percent. Exhibit 11.10 shows the yen/dollar exchange rate to be paid by the importer over time. As the spot rate changes, the forward rate will often change by a similar amount. Thus, if the spot rate increases by 10 percent over the year, the forward rate may increase by about the same amount, and the importer will pay 10 percent more for next year’s shipment (assuming no change in the yen price quoted by the Japanese exporter). The use of a one-year forward contract during a strong-yen cycle is preferable to no hedge in this case but will still result in

E X A M P L E

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327

subsequent increases in prices paid by the importer each year. This illustrates that the use of short-term hedging techniques does not completely insulate a firm from exchange rate exposure, even if the hedges are used repeatedly over time. ■

If the hedging techniques can be applied to longer-term periods, they can more effectively insulate the ﬁ rm from exchange rate risk over the long run. That is, Winthrop Co. could, as of time 0, create a hedge for shipments to arrive at the end of each of the next several years. The forward rate for each hedge would be based on the spot rate as of today, as shown in Exhibit 11.11. During a strong-yen cycle, such a strategy would save a substantial amount of money. Exhibit 11.10 Illustration of Repeated Hedging of Foreign Payables When the Foreign Currency is Appreciating

Forward Rate and Spot Rate

Forward Rate Spot Rate

Savings from Hedging

0

1

2

3

Year

Forward Rate (FR) and Spot Rate (SR)

Exhibit 11.11 Long-Term Hedging of Payables When the Foreign Currency Is Appreciating

SR Savings from Hedging

1-yr. FR

0

1 Year

2-yr. FR

3-yr. FR

2

3

328

Part 3: Exchange Rate Risk Management

This strategy faces a limitation, however, in that the amount in yen to be hedged further into the future is more uncertain because the shipment size will be dependent on economic conditions or other factors at that time. If a recession occurs, Winthrop Co. may reduce the number of CD players ordered, but the amount in yen to be received by the importer is dictated by the forward contract that was created. If the CD player manufacturer goes bankrupt, or simply experiences stockouts, Winthrop Co. is still obligated to purchase the yen, even if a shipment is not forthcoming. Given the greater uncertainty surrounding the amount of currency to be hedged, some MNCs focus more on hedging receivables or payables that will occur in the near future. Symantec commonly has forward contracts valued at more than $100 million to hedge transaction exposure, and all or most of the contracts have maturities of less than 35 days. Conversely, Procter & Gamble commonly uses forward contracts with maturities up to 18 months. In some cases Procter & Gamble hedges exposure 5 years ahead.

Hedging Long-Term Transaction Exposure Some MNCs are certain of having cash ﬂows denominated in foreign currencies for several years and attempt to use long-term hedging. For example, Walt Disney Co. hedged its Japanese yen cash ﬂows that will be remitted to the United States (from its Japanese theme park) 20 years ahead. Eastman Kodak Co. and General Electric Co. incorporate foreign exchange management into their long-term corporate planning. Thus, techniques for hedging long-term exchange rate exposure are needed. Firms that can accurately estimate foreign currency payables or receivables that will occur several years from now commonly use two techniques to hedge such longterm transaction exposure: • Long-term forward contract • Parallel loan Each technique is discussed in turn.

Long-Term Forward Contract Until recently, long-term forward contracts, or long forwards, were seldom used. Today, the long forward is quite popular. Most large international banks routinely quote forward rates for terms of up to 5 years for British pounds, Canadian dollars, Japanese yen, and Swiss francs. Long forwards are especially attractive to ﬁ rms that have set up ﬁ xed-price exporting or importing contracts over a long period of time and want to protect their cash ﬂow from exchange rate ﬂuctuations. Like a short-term forward contract, the long forward can be tailored to accommodate the speciﬁc needs of the ﬁ rm. Maturities of up to 10 years or more can sometimes be set up for the major currencies. Because a bank is trusting that the ﬁ rm will fulﬁ ll its long-term obligation speciﬁed in the forward contract, it will consider only very creditworthy customers.

Parallel Loan A parallel loan (or “back-to-back loan”) involves an exchange of currencies between two parties, with a promise to reexchange currencies at a speciﬁed exchange rate on a future date. It represents two swaps of currencies, one swap at the inception of the loan contract and another swap at the speciﬁed future date. A parallel loan is interpreted by accountants as a loan and is therefore recorded on ﬁ nancial statements. It is covered in more detail in Chapter 18.

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Alternative Hedging Techniques When a perfect hedge is not available (or is too expensive) to eliminate transaction exposure, the ﬁ rm should consider methods to at least reduce exposure. Such methods include the following: • Leading and lagging • Cross-hedging • Currency diversiﬁcation Each method is discussed in turn.

Leading and Lagging Leading and lagging strategies involve adjusting the timing of a payment request or disbursement to reﬂect expectations about future currency movements. Corvalis Co. is based in the United States and has subsidiaries dispersed around the world. The focus here will be on a subsidiary in the United Kingdom that purchases some of its supplies from a subsidiary in Hungary. These supplies are denominated in Hungary’s currency (the forint). If Corvalis Co. expects that the pound will soon depreciate against the forint, it may attempt to expedite the payment to Hungary before the pound depreciates. This strategy is referred to as leading. As a second scenario, assume that the British subsidiary expects the pound to appreciate against the forint soon. In this case, the British subsidiary may attempt to stall its payment until after the pound appreciates. In this way it could use fewer pounds to obtain the forint needed for payment. This strategy is referred to as lagging. ■

E X A M P L E

General Electric and other well-known MNCs commonly use leading and lagging strategies in countries that allow them. In some countries, the government limits the length of time involved in leading and lagging strategies so that the ﬂ ow of funds into or out of the country is not disrupted. Consequently, an MNC must be aware of government restrictions in any countries where it conducts business before using these strategies.

Cross-Hedging Cross-hedging is a common method of reducing transaction exposure when the cur-

rency cannot be hedged. Greeley Co., a U.S. firm, has payables in zloty (Poland’s currency) 90 days from now. Because it is worried that the zloty may appreciate against the U.S. dollar, it may desire to hedge this position. If forward contracts and other hedging techniques are not possible for the zloty, Greeley may consider cross-hedging. In this case, it needs to first identify a currency that can be hedged and is highly correlated with the zloty. Greeley notices that the euro has recently been moving in tandem with the zloty and decides to set up a 90-day forward contract on the euro. If the movements in the zloty and euro continue to be highly correlated relative to the U.S. dollar (that is, they move in a similar direction and degree against the U.S. dollar), then the exchange rate between these two currencies should be somewhat stable over time. By purchasing euros 90 days forward, Greeley Co. can then exchange euros for the zloty. ■

E X A M P L E

This type of hedge is sometimes referred to as a proxy hedge because the hedged position is in a currency that serves as a proxy for the currency in which the MNC is exposed. The effectiveness of this strategy depends on the degree to which these two currencies are positively correlated. The stronger the positive correlation, the more effective will be the cross-hedging strategy.

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Part 3: Exchange Rate Risk Management

Currency Diversification A third method for reducing transaction exposure is currency diversiﬁcation, which can limit the potential effect of any single currency’s movements on the value of an MNC. Some MNCs, such as The Coca-Cola Co., PepsiCo, and Altria, claim that their exposure to exchange rate movements is signiﬁcantly reduced because they diversify their business among numerous countries. The dollar value of future inﬂows in foreign currencies will be more stable if the foreign currencies received are not highly positively correlated. The reason is that lower positive correlations or negative correlations can reduce the variability of the dollar value of all foreign currency inﬂows. If the foreign currencies were highly correlated with each other, diversifying among them would not be a very effective way to reduce risk. If one of the currencies substantially depreciated, the others would do so as well, given that all these currencies move in tandem.

SUMMARY ■ To hedge payables, a futures or forward contract on the foreign currency can be purchased. Alternatively, a money market hedge strategy can be used; in this case, the MNC borrows its home currency and converts the proceeds into the foreign currency that will be needed in the future. Finally, call options on the foreign currency can be purchased. ■ To hedge receivables, a futures or forward contract on the foreign currency can be sold. Alternatively, a money market hedge strategy can be used. In this case, the MNC borrows the foreign currency to be received and converts the funds into its home currency; the loan is to be repaid by the receivables. Finally, put options on the foreign currency can be purchased. ■ Futures contracts and forward contracts normally yield similar results. Forward contracts are more ﬂexible because they are not standardized. The money

POINT

market hedge yields results similar to those of the forward hedge if interest rate parity exists. The currency options hedge has an advantage over the other hedging techniques in that the options do not have to be exercised if the MNC would be better off unhedged. A premium must be paid to purchase the currency options, however, so there is a cost for the ﬂexibility they provide. ■ Long-term hedging can be accomplished by using long-term forward contracts that match the date of the payables or receivables. Alternatively, a parallel loan involves the exchange of currencies between two parties, with a promise to reexchange currencies at a speciﬁed exchange rate on a future date. ■ When hedging techniques are not available, there are still some methods of reducing transaction exposure, such as leading and lagging, cross-hedging, and currency diversiﬁcation.

COUNTER-POINT

Should an MNC Risk Overhedging? Point Yes. MNCs have some “unanticipated” transactions that occur without any advance notice. They should attempt to forecast the net cash ﬂows in each currency due to unanticipated transactions based on the previous net cash ﬂows for that currency in a previous period. Even though it would be impossible to forecast the volume of these unanticipated transactions per day, it may be possible to forecast the volume on a monthly basis. For example, if an MNC has net cash ﬂows between 3 million and 4 million Philippine pesos every month, it may presume that it will receive at

least 3 million pesos in each of the next few months unless conditions change. Thus, it can hedge a position of 3 million in pesos by selling that amount of pesos forward or buying put options on that amount of pesos. Any amount of net cash ﬂows beyond 3 million pesos will not be hedged, but at least the MNC was able to hedge the minimum expected net cash ﬂows. Counter-Point No. MNCs should not hedge unanticipated transactions. When they overhedge the expected net cash ﬂows in a foreign currency, they are

Chapter 11: Managing Transaction Exposure

ing does not insulate an MNC against exchange rate risk. It just changes the means by which the MNC is exposed.

still exposed to exchange rate risk. If they sell more currency as a result of forward contracts than their net cash ﬂows, they will be adversely affected by an increase in the value of the currency. Their initial reasons for hedging were to protect against the weakness of the currency, but the overhedging described here would cause a shift in their exposure. Overhedg-

SELF

331

Who Is Correct? Use the Internet to learn more about this issue. Offer your own opinion on this issue.

TEST

Answers are provided in Appendix A at the back of the text. 1. Montclair Co., a U.S. ﬁ rm, plans to use a money market hedge to hedge its payment of 3 million Australian dollars for Australian goods in one year. The U.S. interest rate is 7 percent, while the Australian interest rate is 12 percent. The spot rate of the Australian dollar is $.85, while the one-year forward rate is $.81. Determine the amount of U.S. dollars needed in one year if a money market hedge is used. 2. Using the information in the previous question, would Montclair Co. be better off hedging the payables with a money market hedge or with a forward hedge? 3. Using the information about Montclair from the ﬁ rst question, explain the possible advantage of a currency option hedge over a money market hedge for Montclair Co. What is a possible disadvantage of the currency option hedge?

QUESTIONS

AND

A P P L I CAT I O N S

1. Consolidated Exposure. Quincy Corp. estimates the following cash ﬂows in 90 days at its subsidiaries as follows: Net Position in Each Currency Measured in the Parent’s Currency (in 1,000s of Units) Subsidiary

Currency 1

Currency 2

Currency 3

A

200

300

100

B

100

40

10

C

180

200

40

4. Sanibel Co. purchases British goods (denominated in pounds) every month. It negotiates a one-month forward contract at the beginning of every month to hedge its payables. Assume the British pound appreciates consistently over the next 5 years. Will Sanibel be affected? Explain. 5. Using the information from question 4, suggest how Sanibel Co. could more effectively insulate itself from the possible long-term appreciation of the British pound. 6. Hopkins Co. transported goods to Switzerland and will receive 2 million Swiss francs in 3 months. It believes the 3-month forward rate will be an accurate forecast of the future spot rate. The 3-month forward rate of the Swiss franc is $.68. A put option is available with an exercise price of $.69 and a premium of $.03. Would Hopkins prefer a put option hedge to no hedge? Explain.

Determine the consolidated net exposure of the MNC to each currency. 2. Money Market Hedge on Receivables. Assume that Stevens Point Co. has net receivables of 100,000 Singapore dollars in 90 days. The spot rate of the S$ is $.50, and the Singapore interest rate is 2 percent

over 90 days. Suggest how the U.S. ﬁ rm could implement a money market hedge. Be precise. 3. Money Market Hedge on Payables. Assume that Vermont Co. has net payables of 200,000 Mexican pesos in 180 days. The Mexican interest rate is 7 percent over 180 days, and the spot rate of the Mexican peso is $.10. Suggest how the U.S. ﬁ rm could implement a money market hedge. Be precise. 4. Invoicing Strategy. Assume that Citadel Co. purchases some goods in Chile that are denominated in Chilean pesos. It also sells goods denominated in U.S. dollars to some ﬁ rms in Chile. At the end of each month, it has a large net payables position in Chilean pesos. How can it use an invoicing strategy to reduce this transaction exposure? List any limitations on the effectiveness of this strategy. 5. Hedging with Futures. Explain how a U.S. corporation could hedge net receivables in euros with futures contracts. Explain how a U.S. corporation

332

Part 3: Exchange Rate Risk Management

could hedge net payables in Japanese yen with futures contracts. 6. Hedging with Forward Contracts. Explain how a U.S. corporation could hedge net receivables in Malaysian ringgit with a forward contract. Explain how a U.S. corporation could hedge payables in Canadian dollars with a forward contract. 7. Real Cost of Hedging Payables. Assume that Loras Corp. imported goods from New Zealand and needs 100,000 New Zealand dollars 180 days from now. It is trying to determine whether to hedge this position. Loras has developed the following probability distribution for the New Zealand dollar: Possible Value of New Zealand Dollar in 180 Days $.40

a 90-day forward contract. Why may Kayla believe that it will pay a smaller amount of dollars when hedging than if it remains unhedged? 11. Forward versus Money Market Hedge on Payables. Assume the following information: 90-day U.S. interest rate

4%

90-day Malaysian interest rate

3%

90-day forward rate of Malaysian ringgit

$.400

Spot rate of Malaysian ringgit

$.404

Assume that the Santa Barbara Co. in the United States will need 300,000 ringgit in 90 days. It wishes to hedge this payables position. Would it be better off using a forward hedge or a money market hedge? Substantiate your answer with estimated costs for each type of hedge.

Probability 5%

.45

10

.48

30

.50

30

.53

20

.55

5

The 180-day forward rate of the New Zealand dollar is $.52. The spot rate of the New Zealand dollar is $.49. Develop a table showing a feasibility analysis for hedging. That is, determine the possible differences between the costs of hedging versus no hedging. What is the probability that hedging will be more costly to the ﬁ rm than not hedging? Determine the expected value of the additional cost of hedging. 8. Beneﬁts of Hedging. If hedging is expected to be more costly than not hedging, why would a ﬁ rm even consider hedging? 9. Real Cost of Hedging Payables. Assume that Suffolk Co. negotiated a forward contract to purchase 200,000 British pounds in 90 days. The 90-day forward rate was $1.40 per British pound. The pounds to be purchased were to be used to purchase British supplies. On the day the pounds were delivered in accordance with the forward contract, the spot rate of the British pound was $1.44. What was the real cost of hedging the payables for this U.S. ﬁ rm? 10. Forward Hedge Decision. Kayla Co. imports products from Mexico, and it will make payment in pesos in 90 days. Interest rate parity holds. The prevailing interest rate in Mexico is very high, which reﬂects the high expected inﬂation there. Kayla expects that the Mexican peso will depreciate over the next 90 days. Yet, it plans to hedge its payables with

12. Forward versus Money Market Hedge on Receivables. Assume the following information: 180-day U.S. interest rate

8%

180-day British interest rate

9%

180-day forward rate of British pound

$1.50

Spot rate of British pound

$1.48

13.

14.

15. 16.

Assume that Riverside Corp. from the United States will receive 400,000 pounds in 180 days. Would it be better off using a forward hedge or a money market hedge? Substantiate your answer with estimated revenue for each type of hedge. Currency Options. Relate the use of currency options to hedging net payables and receivables. That is, when should currency puts be purchased, and when should currency calls be purchased? Why would Cleveland, Inc., consider hedging net payables or net receivables with currency options rather than forward contracts? What are the disadvantages of hedging with currency options as opposed to forward contracts? Currency Options. Can Brooklyn Co. determine whether currency options will be more or less expensive than a forward hedge when considering both hedging techniques to cover net payables in euros? Why or why not? Long-Term Hedging. How can a ﬁ rm hedge longterm currency positions? Elaborate on each method. Leading and Lagging. Under what conditions would Zona Co.’s subsidiary consider using a leading strategy to reduce transaction exposure? Under what conditions would Zona Co.’s subsidiary consider using a lagging strategy to reduce transaction exposure?

Chapter 11: Managing Transaction Exposure

17. Cross-Hedging. Explain how a ﬁ rm can use crosshedging to reduce transaction exposure. 18. Currency Diversiﬁcation. Explain how a ﬁ rm can use currency diversiﬁcation to reduce transaction exposure. 19. Hedging with Put Options. As treasurer of Tucson Corp. (a U.S. exporter to New Zealand), you must decide how to hedge (if at all) future receivables of 250,000 New Zealand dollars 90 days from now. Put options are available for a premium of $.03 per unit and an exercise price of $.49 per New Zealand dollar. The forecasted spot rate of the NZ$ in 90 days follows: Future Spot Rate

Probability

$.44

30%

.40

50

.38

20

Given that you hedge your position with options, create a probability distribution for U.S. dollars to be received in 90 days. 20. Forward Hedge. Would Oregon Co.’s real cost of hedging Australian dollar payables every 90 days have been positive, negative, or about zero on average over a period in which the dollar weakened consistently? What does this imply about the forward rate as an unbiased predictor of the future spot rate? Explain. 21. Implications of IRP for Hedging. If interest rate parity exists, would a forward hedge be more favorable, the same as, or less favorable than a money market hedge on euro payables? Explain. 22. Real Cost of Hedging. Would Montana Co.’s real cost of hedging Japanese yen receivables have been positive, negative, or about zero on average over a period in which the dollar weakened consistently? Explain. 23. Forward versus Options Hedge on Payables. If you are a U.S. importer of Mexican goods and you

Scenario

Spot Rate of Pound 90 Days from Now

1

$1.65

2

1.70

3

1.75

4

1.80

5

1.85

333

believe that today’s forward rate of the peso is a very accurate estimate of the future spot rate, do you think Mexican peso call options would be a more appropriate hedge than the forward hedge? Explain. 24. Forward versus Options Hedge on Receivables. You are an exporter of goods to the United Kingdom, and you believe that today’s forward rate of the British pound substantially underestimates the future spot rate. Company policy requires you to hedge your British pound receivables in some way. Would a forward hedge or a put option hedge be more appropriate? Explain. 25. Forward Hedging. Explain how a Malaysian ﬁ rm can use the forward market to hedge periodic purchases of U.S. goods denominated in U.S. dollars. Explain how a French ﬁ rm can use forward contracts to hedge periodic sales of goods sold to the United States that are invoiced in dollars. Explain how a British ﬁ rm can use the forward market to hedge periodic purchases of Japanese goods denominated in yen. 26. Continuous Hedging. Cornell Co. purchases computer chips denominated in euros on a monthly basis from a Dutch supplier. To hedge its exchange rate risk, this U.S. ﬁ rm negotiates a 3-month forward contract 3 months before the next order will arrive. In other words, Cornell is always covered for the next three monthly shipments. Because Cornell consistently hedges in this manner, it is not concerned with exchange rate movements. Is Cornell insulated from exchange rate movements? Explain. 27. Hedging Payables with Currency Options. Malibu, Inc., is a U.S. company that imports British goods. It plans to use call options to hedge payables of 100,000 pounds in 90 days. Three call options are available that have an expiration date 90 days from now. Fill in the number of dollars needed to pay for the payables (including the option premium paid) for each option available under each possible scenario in the following table:

Exercise Price $1.74; Premium = $.06

Exercise Price = $1.76; Premium = $.05

Exercise Price = $1.79; Premium = $.03

334

Part 3: Exchange Rate Risk Management

If each of the ﬁve scenarios had an equal probability of occurrence, which option would you choose? Explain. 28. Forward Hedging. Wedco Technology of New Jersey exports plastics products to Europe. Wedco decided to price its exports in dollars. Telematics International, Inc. (of Florida), exports computer network systems to the United Kingdom (denominated in British pounds) and other countries. Telematics decided to use hedging techniques such as forward contracts to hedge its exposure.

Advanced Questions 32. Comparison of Techniques for Hedging Receivables. a. Assume that Carbondale Co. expects to receive S$500,000 in one year. The existing spot rate of the Singapore dollar is $.60. The one-year forward rate of the Singapore dollar is $.62. Carbondale created a probability distribution for the future spot rate in one year as follows:

Future Spot Rate

Probability

a. Does Wedco’s strategy of pricing its materials for

$.61

20%

European customers in dollars avoid economic exposure? Explain.

.63

50

.67

30

b. Explain why the earnings of Telematics Interna-

tional, Inc., were affected by changes in the value of the pound. Why might Telematics leave its exposure unhedged sometimes? 29. The Long-Term Hedge Dilemma. St. Louis, Inc., which relies on exporting, denominates its exports in pesos and receives pesos every month. It expects the peso to weaken over time. St. Louis recognizes the limitation of monthly hedging. It also recognizes that it could remove its transaction exposure by denominating its exports in dollars, but it would still be subject to economic exposure. The longterm hedging techniques are limited, and the ﬁ rm does not know how many pesos it will receive in the future, so it would have difﬁculty even if a longterm hedging method was available. How can this business realistically reduce its exposure over the long term? 30. Long-Term Hedging. Since Obisbo, Inc., conducts much business in Japan, it is likely to have cash ﬂows in yen that will periodically be remitted by its Japanese subsidiary to the U.S. parent. What are the limitations of hedging these remittances one year in advance over each of the next 20 years? What are the limitations of creating a hedge today that will hedge these remittances over each of the next 20 years? 31. Hedging during the Asian Crisis. Describe how the Asian crisis could have reduced the cash ﬂows of a U.S. ﬁ rm that exported products (denominated in U.S. dollars) to Asian countries. How could a U.S. ﬁ rm that exported products (denominated in U.S. dollars) to Asia, and anticipated the Asian crisis before it began, have insulated itself from any currency effects while continuing to export to Asia?

Assume that one-year put options on Singapore dollars are available, with an exercise price of $.63 and a premium of $.04 per unit. One-year call options on Singapore dollars are available with an exercise price of $.60 and a premium of $.03 per unit. Assume the following money market rates: U.S.

Singapore

Deposit rate

8%

5%

Borrowing rate

9

6

Given this information, determine whether a forward hedge, a money market hedge, or a currency options hedge would be most appropriate. Then compare the most appropriate hedge to an unhedged strategy, and decide whether Carbondale should hedge its receivables position. b. Assume that Baton Rouge, Inc., expects to need S$1 million in one year. Using any relevant information in part (a) of this question, determine whether a forward hedge, a money market hedge, or a currency options hedge would be most appropriate. Then, compare the most appropriate hedge to an unhedged strategy, and decide whether Baton Rouge should hedge its payables position.

33. Comparison of Techniques for Hedging Payables. SMU Corp. has future receivables of 4 million New Zealand dollars (NZ$) in one year. It must decide whether to use options or a money market hedge to hedge this position. Use any of the following information to make the decision. Verify your answer by determining the estimate (or probability distribution) of dollar revenue to be received in one year for each type of hedge.

Chapter 11: Managing Transaction Exposure Spot rate of NZ$

$.54

a 0 0.0

One-year call option

Exercise price $.50; premium $.07

a1 1.1

One-year put option

Exercise price $.52; premium $.03 U.S.

One-year deposit rate

9%

One-year borrowing rate

Forecasted spot rate of NZ$

New Zealand

335

a2 0.6 Assume last year’s inﬂation rates were 3 percent for the United States and 8 percent for the United Kingdom. Also assume that the interest rate differential (DINTt) is forecasted as follows for this year:

6%

11

8

Rate

Probability

$.50

Forecast of DINTt

Probability

1%

40%

20%

2

50

.51

50

3

10

.53

30

34. Exposure to September 11. If you were a U.S. importer of products from Europe, explain whether the September 11, 2001, terrorist attacks on the United States would have caused you to hedge your payables (denominated in euros) due a few months later. Keep in mind that the attack was followed by a reduction in U.S. interest rates. 35. Hedging with Forward versus Option Contracts. As treasurer of Tempe Corp., you are confronted with the following problem. Assume the one-year forward rate of the British pound is $1.59. You plan to receive 1 million pounds in one year. A one-year put option is available. It has an exercise price of $1.61. The spot rate as of today is $1.62, and the option premium is $.04 per unit. Your forecast of the percentage change in the spot rate was determined from the following regression model: et a 0 a1DINFt1 a2DINT t m where et percentage change in British pound value over period t DINFt1 differential in inﬂation between the United States and the United Kingdom in period t 1 DINTt average differential between U.S. interest rate and British interest rate over period t a 0, a1, and a2 regression coefﬁcients m error term The regression model was applied to historical annual data, and the regression coefﬁcients were estimated as follows:

Using any of the available information, should the treasurer choose the forward hedge or the put option hedge? Show your work. 36. Hedging Decision. You believe that IRP presently exists. The nominal annual interest rate in Mexico is 14 percent. The nominal annual interest rate in the United States is 3 percent. You expect that annual inﬂation will be about 4 percent in Mexico and 5 percent in the United States. The spot rate of the Mexican peso is $.10. Put options on pesos are available with a one-year expiration date, an exercise price of $.1008, and a premium of $.014 per unit. You will receive 1 million pesos in one year. a. Determine the expected amount of dollars that

you will receive if you use a forward hedge. b. Determine the expected amount of dollars that

you will receive if you do not hedge and believe in purchasing power parity (PPP). c. Determine the amount of dollars that you will

expect to receive if you believe in PPP and use a currency put option hedge. Account for the premium you would pay on the put option. 37. Forecasting with IFE and Hedging. Assume that Calumet Co. will receive 10 million pesos in 15 months. It does not have a relationship with a bank at this time and, therefore, cannot obtain a forward contract to hedge its receivables at this time. However, in 3 months, it will be able to obtain a one-year (12-month) forward contract to hedge its receivables. Today the 3-month U.S. interest rate is 2 percent (not annualized), the 12-month U.S. interest rate is 8 percent, the 3-month Mexican peso interest rate is 5 percent (not annualized), and the 12-month peso interest rate is 20 percent. Assume that interest rate parity exists. Assume the international Fisher effect exists.

336

Part 3: Exchange Rate Risk Management

Assume that the existing interest rates are expected to remain constant over time. The spot rate of the Mexican peso today is $.10. Based on this information, estimate the amount of dollars that Calumet Co. will receive in 15 months. 38. Forecasting from Regression Analysis and Hedging. You apply a regression model to annual data in which the annual percentage change in the British pound is the dependent variable, and INF (deﬁ ned as annual U.S. inﬂation minus U.K. inﬂation) is the independent variable. Results of the regression analysis show an estimate of 0.0 for the intercept and 1.4 for the slope coefﬁcient. You believe that your model will be useful to predict exchange rate movements in the future. You expect that inﬂation in the United States will be 3 percent, versus 5 percent in the United Kingdom. There is an 80 percent chance of that scenario. However, you think that oil prices could rise, and if so, the annual U.S. inﬂation rate will be 8 percent instead of 3 percent (and the annual U.K. inﬂation will still be 5 percent). There is a 20 percent chance that this scenario will occur. You think that the inﬂation differential is the only variable that will affect the British pound’s exchange rate over the next year. The spot rate of the pound as of today is $1.80. The annual interest rate in the United States is 6 percent versus an annual interest rate in the United Kingdom of 8 percent. Call options are available with an exercise price of $1.79, an expiration date of one year from today, and a premium of $.03 per unit. Your ﬁ rm in the United States expects to need 1 million pounds in one year to pay for imports. You can use any one of the following strategies to deal with the exchange rate risk: a. Unhedged strategy b. Money market hedge c. Call option hedge

Estimate the dollar cash ﬂows you will need as a result of using each strategy. If the estimate for a particular strategy involves a probability distribution, show the distribution. Which hedge is optimal? 39. Forecasting Cash Flows and Hedging Decision. Virginia Co. has a subsidiary in Hong Kong and in Thailand. Assume that the Hong Kong dollar is pegged at $.13 per Hong Kong dollar and it will remain pegged. The Thai baht ﬂuctuates against the U.S. dollar, and is presently worth $.03. Virginia Co. expects that during this year, the U.S. inﬂation rate will be 2 percent, the Thailand inﬂation rate will be 11 percent, while the Hong Kong inﬂation

rate will be 3 percent. Virginia Co. expects that purchasing power parity will hold for any exchange rate that is not ﬁ xed (pegged). The parent of Virginia Co. will receive 10 million Thai baht and 10 million Hong Kong dollars at the end of one year from its subsidiaries. a. Determine the expected amount of dollars to be received by the U.S. parent from the Thai subsidiary in one year when the baht receivables are converted to U.S. dollars. b. The Hong Kong subsidiary will send HK$1 million to make a payment for supplies to the Thai subsidiary. Determine the expected amount of baht that will be received by the Thai subsidiary when the Hong Kong dollar receivables are converted to Thai baht. c. Assume that interest rate parity exists. Also assume that the real one-year interest rate in the United States is presumed to be 1.0 percent, while the real interest rate in Thailand is presumed to be 3.0 percent. Determine the expected amount of dollars to be received by the U.S. parent if it uses a one-year forward contract today to hedge the receivables of 10 million baht that will arrive in one year.

40. Hedging Decision. Chicago Co. expects to receive 5 million euros in one year from exports. It can use any one of the following strategies to deal with the exchange rate risk. Estimate the dollar cash ﬂows received as a result of using the following strategies: a. Unhedged strategy b. Money market hedge c. Option hedge

The spot rate of the euro as of today is $1.10. Interest rate parity exists. Chicago uses the forward rate as a predictor of the future spot rate. The annual interest rate in the United States is 8 percent versus an annual interest rate of 5 percent in the euro zone. Put options on euros are available with an exercise price of $1.11, an expiration date of one year from today, and a premium of $.06 per unit. Estimate the dollar cash ﬂows it will receive as a result of using each strategy. Which hedge is optimal? 41. Overhedging. Denver Co. is about to order supplies from Canada that are denominated in Canadian dollars (C$). It has no other transactions in Canada and will not have any other transactions in the future. The supplies will arrive in one year and payment is due at that time. There is only one supplier in Canada. Denver submits an order for three loads of supplies, which will be priced at C$3 million. Denver Co. purchases C$3 million one year forward, since it anticipates that the Canadian dollar will appreciate substantially over the year.

Chapter 11: Managing Transaction Exposure

The existing spot rate is $.62, while the one-year forward rate is $.64. The supplier is not sure if it will be able to provide the full order, so it only guarantees Denver Co. that it will ship one load of supplies. In this case, the supplies will be priced at C$1 million. Denver Co. will not know whether it will receive one load or three loads until the end of the year. Determine Denver’s total cash outﬂows in U.S. dollars under the scenario that the Canadian supplier only provides one load of supplies and that the spot rate of the Canadian dollar at the end of one year is $.59. Show your work. 42. Long-Term Hedging with Forward Contracts. Tampa Co. will build airplanes and export them to Mexico for delivery in 3 years. The total payment to be received in 3 years for these exports is 900 million pesos. Today the peso’s spot rate is $.10. The annual U.S. interest rate is 4 percent, regardless of the debt maturity. The annual peso interest rate is 9 percent regardless of the debt maturity. Tampa plans to hedge its exposure with a forward contract that it will arrange today. Assume that interest rate parity exists. Determine the dollar amount that Tampa will receive in 3 years. 43. Timing the Hedge. Red River Co. (a U.S. ﬁ rm) purchases imports that have a price of 400,000 Singapore dollars, and it has to pay for the imports in 90 days. It will use a 90-day forward contract to cover its payables. Assume that interest rate parity exists. This morning, the spot rate of the Singapore dollar was $.50. At noon, the Federal Reserve reduced U.S. interest rates, while there was no change in interest rates in Singapore. The Fed’s actions immediately increased the degree of uncertainty surrounding the future value of the Singapore dollar over the next 3 months. The Singapore dollar’s spot rate remained at $.50 throughout the day. Assume that the U.S. and Singapore interest rates were the same as of this morning. Also assume that the international Fisher effect holds. If Red River Co. purchased a currency call option contract at the money this morning to hedge its exposure, would its total U.S. dollar cash outﬂows be more than, less than, or the same as the total U.S. dollar cash outﬂows if it had negotiated a forward contract this morning? Explain. 44. Hedging with Forward versus Option Contracts. Assume interest rate parity exists. Today, the oneyear interest rate in Canada is the same as the oneyear interest rate in the United States. Utah Co. uses the forward rate to forecast the future spot rate of the Canadian dollar that will exist in one year. It needs to purchase Canadian dollars in one year.

337

Will the expected cost of its payables be lower if it hedges its payables with a one-year forward contract on Canadian dollars or a one-year at-the-money call option contract on Canadian dollars? Explain. 45. Hedging with a Bull Spread. (See the chapter appendix.) Evar Imports, Inc., buys chocolate from Switzerland and resells it in the United States. It just purchased chocolate invoiced at SF62,500. Payment for the invoice is due in 30 days. Assume that the current exchange rate of the Swiss franc is $.74. Also assume that three call options for the franc are available. The ﬁ rst option has a strike price of $.74 and a premium of $.03; the second option has a strike price of $.77 and a premium of $.01; the third option has a strike price of $.80 and a premium of $.006. Evar Imports is concerned about a modest appreciation in the Swiss franc. a. Describe how Evar Imports could construct a

bull spread using the ﬁ rst two options. What is the cost of this hedge? When is this hedge most effective? When is it least effective? b. Describe how Evar Imports could construct a

bull spread using the ﬁ rst option and the third option. What is the cost of this hedge? When is this hedge most effective? When is it least effective? c. Given your answers to parts (a) and (b), what is

the tradeoff involved in constructing a bull spread using call options with a higher exercise price? 46. Hedging with a Bear Spread. (See the chapter appendix.) Marson, Inc., has some customers in Canada and frequently receives payments denominated in Canadian dollars (C$). The current spot rate for the Canadian dollar is $.75. Two call options on Canadian dollars are available. The ﬁ rst option has an exercise price of $.72 and a premium of $.03. The second option has an exercise price of $.74 and a premium of $.01. Marson, Inc., would like to use a bear spread to hedge a receivable position of C$50,000, which is due in one month. Marson is concerned that the Canadian dollar may depreciate to $.73 in one month. a. Describe how Marson, Inc., could use a bear

spread to hedge its position. b. Assume the spot rate of the Canadian dollar in

one month is $.73. Was the hedge effective? 47. Hedging with Straddles. (See the chapter appendix.) Brooks, Inc., imports wood from Morocco. The Moroccan exporter invoices in Moroccan dirham. The current exchange rate of the dirham is $.10. Brooks just purchased wood for 2 million dirham and should pay for the wood in 3 months. It is also possible that Brooks will receive 4 million dirham in 3 months from the sale of reﬁ nished

338

Part 3: Exchange Rate Risk Management

wood in Morocco. Brooks is currently in negotiations with a Moroccan importer about the reﬁ nished wood. If the negotiations are successful, Brooks will receive the 4 million dirham in 3 months, for a net cash inﬂow of 2 million dirham. The following option information is available: • Call option premium on Moroccan dirham

$.003. • Put option premium on Moroccan dirham

$.002. • Call and put option strike price $.098. • One option contract represents 500,000 dirham. a. Describe how Brooks could use a straddle to

hedge its possible positions in dirham. b. Consider three scenarios. In the ﬁ rst scenario,

the dirham’s spot rate at option expiration is equal to the exercise price of $.098. In the second scenario, the dirham depreciates to $.08. In the third scenario, the dirham appreciates to $.11. For each scenario, consider both the case when the negotiations are successful and the case when the nego-

BLADES,

INC.

tiations are not successful. Assess the effectiveness of the long straddle in each of these situations by comparing it to a strategy of using long call options to hedge. 48. Hedging with Straddles versus Strangles. (See the chapter appendix.) Refer to the previous problem. Assume that Brooks believes the cost of a long straddle is too high. However, call options with an exercise price of $.105 and a premium of $.002 and put options with an exercise price of $.09 and a premium of $.001 are also available on Moroccan dirham. Describe how Brooks could use a long strangle to hedge its possible dirham positions. What is the tradeoff involved in using a long strangle versus a long straddle to hedge the positions? Discussion in the Boardroom This exercise can be found in Appendix E at the back of this textbook. Running Your Own MNC This exercise can be found on the Xtra! website at http://maduraxtra.swlearning.com.

CASE

Management of Transaction Exposure Blades, Inc., has recently decided to expand its international trade relationship by exporting to the United Kingdom. Jogs, Ltd., a British retailer, has committed itself to the annual purchase of 200,000 pairs of “Speedos,” Blades’ primary product, for a price of £80 per pair. The agreement is to last for 2 years, at which time it may be renewed by Blades and Jogs. In addition to this new international trade relationship, Blades continues to export to Thailand. Its primary customer there, a retailer called Entertainment Products, is committed to the purchase of 180,000 pairs of Speedos annually for another 2 years at a ﬁ xed price of 4,594 Thai baht per pair. When the agreement terminates, it may be renewed by Blades and Entertainment Products. Blades also incurs costs of goods sold denominated in Thai baht. It imports materials sufﬁcient to manufacture 72,000 pairs of Speedos annually from Thailand. These imports are denominated in baht, and the price depends on current market prices for the rubber and plastic components imported. Under the two export arrangements, Blades sells quarterly amounts of 50,000 and 45,000 pairs of Speedos to Jogs and Entertainment Products, respectively. Payment for these sales is made on the ﬁ rst of January, April, July, and October. The annual amounts

are spread over quarters in order to avoid excessive inventories for the British and Thai retailers. Similarly, in order to avoid excessive inventories, Blades usually imports materials sufﬁcient to manufacture 18,000 pairs of Speedos quarterly from Thailand. Although payment terms call for payment within 60 days of delivery, Blades generally pays for its Thai imports upon delivery on the ﬁ rst day of each quarter in order to maintain its trade relationships with the Thai suppliers. Blades feels that early payment is beneﬁcial, as other customers of the Thai supplier pay for their purchases only when it is required. Since Blades is relatively new to international trade, Ben Holt, Blades’ chief ﬁ nancial ofﬁcer (CFO), is concerned with the potential impact of exchange rate ﬂuctuations on Blades’ ﬁ nancial performance. Holt is vaguely familiar with various techniques available to hedge transaction exposure, but he is not certain whether one technique is superior to the others. Holt would like to know more about the forward, money market, and option hedges and has asked you, a ﬁ nancial analyst at Blades, to help him identify the hedging technique most appropriate for Blades. Unfortunately, no options are available for Thailand, but British call and put options are available for £31,250 per option.

Chapter 11: Managing Transaction Exposure

Ben Holt has gathered and provided you with the following information for Thailand and the United Kingdom:

Thailand

United Kingdom

Current spot rate

$.0230

$1.50

90-day forward rate

$.0215

$1.49

Put option premium

Not available

$.020 per unit

Put option exercise price

Not available

$1.47

Call option premium

Not available

$.015 per unit

Call option exercise price

Not available

$1.48

4%

2%

3.5%

1.8%

90-day borrowing rate (nonannualized) 90-day lending rate (nonannualized)

In addition to this information, Ben Holt has informed you that the 90-day borrowing and lending rates in the United States are 2.3 and 2.1 percent, respectively, on a nonannualized basis. He has also identiﬁed the following probability distributions for the exchange rates of the British pound and the Thai baht in 90 days:

Probability

Spot Rate for the British Pound in 90 Days

Spot Rate for the Thai Baht in 90 Days

5%

$1.45

$.0200

20

1.47

$.0213

30

1.48

$.0217

25

1.49

$.0220

15

1.50

$.0230

5

1.52

$.0235

SMALL

BUSINESS

339

Blades’ next sales to and purchases from Thailand will occur one quarter from now. If Blades decides to hedge, Holt will want to hedge the entire amount subject to exchange rate ﬂuctuations, even if it requires overhedging (i.e., hedging more than the needed amount). Currently, Holt expects the imported components from Thailand to cost approximately 3,000 baht per pair of Speedos. Holt has asked you to answer the following questions for him: 1. Using a spreadsheet, compare the hedging alternatives for the Thai baht with a scenario under which Blades remains unhedged. Do you think Blades should hedge or remain unhedged? If Blades should hedge, which hedge is most appropriate? 2. Using a spreadsheet, compare the hedging alternatives for the British pound receivables with a scenario under which Blades remains unhedged. Do you think Blades should hedge or remain unhedged? Which hedge is the most appropriate for Blades? 3. In general, do you think it is easier for Blades to hedge its inﬂows or its outﬂows denominated in foreign currencies? Why? 4. Would any of the hedges you compared in question 2 for the British pounds to be received in 90 days require Blades to overhedge? Given Blades’ exporting arrangements, do you think it is subject to overhedging with a money market hedge? 5. Could Blades modify the timing of the Thai imports in order to reduce its transaction exposure? What is the tradeoff of such a modiﬁcation? 6. Could Blades modify its payment practices for the Thai imports in order to reduce its transaction exposure? What is the tradeoff of such a modiﬁcation? 7. Given Blades’ exporting agreements, are there any long-term hedging techniques Blades could beneﬁt from? For this question only, assume that Blades incurs all of its costs in the United States.

DILEMMA

Hedging Decisions by the Sports Exports Company Jim Logan, owner of the Sports Exports Company, will be receiving about 10,000 British pounds about one month from now as payment for exports produced and sent by his ﬁ rm. Jim is concerned about his exposure because he believes that there are two possible scenar-

ios: (1) the pound will depreciate by 3 percent over the next month or (2) the pound will appreciate by 2 percent over the next month. There is a 70 percent chance that Scenario 1 will occur. There is a 30 percent chance that Scenario 2 will occur.

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Jim notices that the prevailing spot rate of the pound is $1.65, and the one-month forward rate is about $1.645. Jim can purchase a put option over the counter from a securities ﬁ rm that has an exercise (strike) price of $1.645, a premium of $.025, and an expiration date of one month from now. 1. Determine the amount of dollars received by the Sports Exports Company if the receivables to be received in one month are not hedged under each of the two exchange rate scenarios. 2. Determine the amount of dollars received by the Sports Exports Company if a put option is used to

I N T E R N E T/ E XC E L 1. The following website contains annual reports of many MNCs: http://www.reportgallery.com. Review the annual report of your choice. Look for any comments in the report that describe the MNC’s hedging of transaction exposure. Summarize the MNC’s hedging of transaction exposure based on the comments in the annual report.

hedge receivables in one month under each of the two exchange rate scenarios. 3. Determine the amount of dollars received by the Sports Exports Company if a forward hedge is used to hedge receivables in one month under each of the two exchange rate scenarios. 4. Summarize the results of dollars received based on an unhedged strategy, a put option strategy, and a forward hedge strategy. Select the strategy that you prefer based on the information provided.

EXERCISES 2. The following website provides exchange rate movements against the dollar over recent months: http://www.federalreserve.gov/releases/. Based on the exposure of the MNC you assessed in question 1, determine whether the exchange rate movements of whatever currency (or currencies) it is exposed to moved in a favorable or unfavorable direction over the last few months.

APPENDIX 11 Incorporating International Tax Laws Nontraditional Hedging Techniques in Multinational Capital Budgeting

While traditional hedging techniques were covered in the chapter, many other techniques may be appropriate for an MNC’s particular situation. Some of these nontraditional techniques are described in this appendix.

Hedging with Currency Straddles In reality, some MNCs do not know whether they will have net cash inﬂows or outﬂows as a result of their transactions in a speciﬁc currency over a particular period of time. A long straddle (purchase of a call option and put option with the same exercise price) is an effective tool to hedge under these conditions. Houston Co. conducts business in Mexico and expects to need 4 million Mexican pesos (MXP) to cover specific expenses. If it is unable to renew a business deal with the Mexican government (its biggest customer), it will receive a total of MXP3 million in revenue in one month, which will result in net cash flows of MXP1 million. Conversely, if it is able to renew the business deal with the government, it will receive a total of MXP5 million, which will result in net cash flows of MXP1 million. The prevailing spot rate of the Mexican peso is $.09. If Houston has excess pesos in one month, it will convert them to dollars. Conversely, if Houston does not have enough pesos in one month, it will use dollars to obtain the amount that it needs. Houston would like to hedge its exchange rate risk, regardless of which scenario occurs. Currently, call options for Mexican pesos with expiration dates in one month are available with an exercise price of $.09 and a premium of $.004 per peso. Put options for Mexican pesos with an expiration date of one month are available with an exercise price of $.09 and a premium of $.005 per peso. Options for Mexican pesos are denominated in 250,000 pesos per option contract. Houston could hedge its possible position of having positive net cash flows of MXP1 million by purchasing put options. It would pay a premium of $5,000 (1,000,000 units $.005). It could hedge its possible position of needing MXP1 million by purchasing call options. It would pay a premium of $4,000 (1,000,000 units $.004). Assume that Houston constructs a straddle to hedge both possible outcomes and pays $9,000 for the call options and put options on pesos. Assume that Houston exercises the options in one month, if at all. Consider the following scenarios that could occur one month from now:

E X X A M P L E

1. If Houston has net cash flows of MXP1 million and the peso’s value is $.10, it would let its put options expire and would convert its pesos to dollars in the spot market, receiving $100,000 (1,000,000 units $.10) from this transaction. It would also exercise its call option by purchasing 1 million pesos at $.09 and selling them in the spot market for $.10. This transaction would generate a gain of $10,000. Overall, Houston would receive $110,000, minus the $9,000 in premiums paid for the options.

341

342

Part 3: Exchange Rate Risk Management

APPENDIX 11

2. If Houston has net cash flows of MXP1 million and the peso depreciates to $.08, it would exercise its put options and let the call options expire. Overall, Houston would receive $90,000 (1,000,000 units $.09) from exercising the options, minus the $9,000 in premiums paid for the options. 3. If Houston has net cash flows of MXP1 million and the peso is $.09, it would let its call and put options expire. It would receive $90,000 (1,000,000 $.09) from selling pesos in the spot market, minus the $9,000 in premiums paid for the options. 4. If Houston has net cash flows of MXP1 million, and the peso’s value is $.10, it would exercise its call options and let its put options expire. Overall, Houston would pay a total of $99,000, which consists of the $90,000 (1,000,000 $.09) from exercising the call option and the $9,000 in premiums paid for the options. 5. If Houston has net cash flows of MXP1 million and the peso’s value is $.08, it would let its call options expire and buy pesos in the spot market. It would also buy 1 million pesos and then sell them by exercising its put options. This transaction would generate a gain of $10,000. Overall, Houston would pay a total of $79,000, which consists of the $80,000 paid to obtain the pesos it needs, plus the $9,000 in premiums paid for the options, minus the $10,000 gain generated from its put options. 6. If Houston has net cash flows of MXP1 million and the peso’s value is $.09, it would let its call and put options expire. It would pay a total of $99,000, which consists of the $90,000 paid to obtain pesos and the $9,000 in premiums paid for the options. Many other scenarios could also occur, but a summary of the possible scenarios and the actions taken by Houston appears in Exhibit 11A.1. ■

Hedging with Currency Strangles In the hedging example just provided for Houston Co., consider that the expected value of the amount that Houston would pay or receive based on today’s spot rate is $90,000 (MXP1,000,000 $.09). The option premiums paid for the options Exhibit 11A.1

Possible Scenarios for Houston Co. When Hedging with a Straddle Panel A: Houston has net cash ﬂows of MXP1,000,000 in one month.

MXP value $.09 in one month

• Houston converts excess pesos to dollars in the spot market. • It lets the put options expire. • It exercises its call options and sells the pesos obtained from this transaction in the spot market; the proceeds recapture part of the premiums that were paid for the options.

MXP value $.09 in one month

• Houston converts excess pesos to dollars at $.09, by exercising its put options. • It lets the call options expire.

MXP value $.09 in one month

• Houston converts excess pesos to dollars in the spot market. • It lets its call options and put options expire.

Panel B: Houston has net cash ﬂows of MXP1,000,000 in one month. MXP value $.09 in one month

• Houston converts dollars to pesos by exercising its call options. • It lets the put options expire.

MXP value $.09 in one month

• It lets the call options expire. • It buys pesos in the spot market and sells pesos obtained by exercising the put options; the proceeds recapture part of the premiums that were paid for the options.

MXP value $.09 in one month

• Houston converts dollars to pesos in the spot market. • It lets its call and put options expire.

Chapter 11: Managing Transaction Exposure

343

Reconsider the example in which Houston Co. expects that it will have net cash flows of either MXP1 million or MXP1 million in one month. To reduce the premiums it pays for hedging with options, it can purchase options that are out of the money. Assume that it can obtain call options for Mexican pesos with an expiration date of one month, an exercise price of $.095, and a premium of $.002 per peso. It can also obtain put options for Mexican pesos with an expiration date of one month, an exercise price of $.085, and a premium of $.003 per peso. Houston Co. could hedge its possible position of needing MXP1 million by purchasing call options. It would pay a premium of $2,000 (1,000,000 units $.002). It could also hedge its possible position of having positive net cash flows of MXP1 million by purchasing put options. It would pay a premium of $3,000 (1,000,000 units $.003). Overall, Houston would pay $5,000 for the call options and put options on pesos, which is substantially less than the $9,000 it would pay for the straddle in the previous example. However, the options do not offer protection until the spot rate deviates by more than $.005 from its existing level. If the spot rate remains within the range of the two exercise prices (from $.085 to $.095), Houston will not exercise either option. This example of hedging with a strangle is a compromise between hedging with the straddle in the previous example and no hedge. For the range of possible spot rates between $.085 and $.095, there is no hedge. For scenarios in which the spot rate moves outside the range, Houston is hedged. It will have to pay no more than $.095 if it needs to obtain pesos and will be able to sell pesos for at least $.085 if it has pesos to sell. ■

E X A M P L E

Hedging with Currency Bull Spreads In certain situations, MNCs can use currency bull spreads to hedge their cash outﬂows denominated in a foreign currency, as the following example illustrates. Peak, Inc., needs to order Canadian raw materials to use in its production process. The Canadian exporter typically invoices Peak in Canadian dollars. Assume that the current exchange rate for the Canadian dollar (C$) is $.73 and that Peak needs C$100,000 in 3 months. Two call options for Canadian dollars with expiration dates in 3 months and the following additional information are available:

E X A M P L E

• Call option 1 premium on Canadian dollars $.015. • Call option 2 premium on Canadian dollars $.008. • Call option 1 strike price $.73. • Call option 2 strike price $.75. • One option contract represents C$50,000. To lock into a future price for the C$100,000, Peak could buy two option 1 contracts, paying 2 C$50,000 $.015 $1,500. This would effectively lock in a maximum price of $.73 that Peak would pay in 3 months, for a total maximum outflow of $74,500 (C$100,000 $.73 $1,500). If the spot price for Canadian dollars at option expiration is below $.73, Peak has the right to let the options expire and buy the C$100,000 in the open market for the lower price. Naturally, Peak would still have paid the $1,500 total premium in this case.

APPENDIX 11

($9,000) represent 10 percent of that expected value. Thus, the straddle is an expensive means of hedging. The exercise price at which Houston hedged was equal to the spot rate (“at the money”). If Houston is willing to accept exposure to small exchange rate movements in the peso, it could reduce the premiums paid for the options. Speciﬁcally, it would use a long strangle by purchasing a call option and a put option that have different exercise prices. By purchasing a call option that has an exercise price higher than $.09, and a put option that has an exercise price lower than $.09, Houston can reduce the premiums it will pay on the options.

APPENDIX 11

344

Part 3: Exchange Rate Risk Management Historically, the Canadian dollar has been relatively stable against the U.S. dollar. If Peak believes that the Canadian dollar will appreciate in the next 3 months but is very unlikely to appreciate above the higher exercise price of $.75, it should consider constructing a bull spread to hedge its Canadian dollar payables. To do so, Peak would purchase two option 1 contracts and write two option 2 contracts. The total cash outflow necessary to construct this bull spread is 2 C$50,000 ($.015 $.008) $700, since Peak would receive the premiums from writing the two option 2 contracts. Constructing the bull spread has reduced the cost of hedging by $800 ($1,500 $700). If the spot price of the Canadian dollar at option expiration is below the $.75 strike price, the bull spread will have provided an effective hedge. For example, if the spot price at option expiration is $.74, Peak will exercise the two option 1 contracts it purchased, for a total maximum outflow of $73,700 (C$100,000 $.73 $700). The buyer of the two option 2 contracts Peak wrote would let those options expire. If the Canadian dollar depreciates substantially below the lower strike price of $.73, the hedge will also be effective, as both options will expire worthless. Peak would purchase the Canadian dollars at the prevailing spot rate, having paid the difference in option premiums. Now consider what will happen if the Canadian dollar appreciates above the higher exercise price of $.75 prior to option expiration. In this case, the bull spread will still reduce the total cash outflow and therefore provide a partial hedge. However, the hedge will be less effective. To illustrate, assume the Canadian dollar appreciates to a spot price of $.80 in 3 months. Peak will still exercise the two option 1 contracts it purchased. However, the two option 2 contracts it wrote will also be exercised. Recall that this is a situation in which the maximum profit from the bull spread is realized, which is equal to the difference in exercise prices less the difference in the two premiums, or 2 C$50,000 ($.75 $.73 $.015 $.008) $1,300. Importantly, Peak will now have to purchase the C$100,000 it needs in the open market, since it needs to sell the Canadian dollars purchased by exercising the option 1 contracts to the buyer of the option 2 contracts it wrote. Therefore, Peak’s total cash outflow in 3 months when it needs the Canadian dollars will be $78,700 (C$100,000 $.80 $1,300). While Peak has successfully reduced its cash outflow in 3 months by $1,300, it would have fared much better by only buying two option 1 contracts to hedge its payables, which would have resulted in a maximum cash outflow of $74,500. Consequently, MNCs should hedge using bull spreads only for relatively stable currencies that are not expected to appreciate drastically prior to option expiration. ■

Hedging with Currency Bear Spreads In certain situations, MNCs can use currency bear spreads to hedge their receivables denominated in a foreign currency. Weber, Inc., has some Canadian customers. Weber typically bills these customers in Canadian dollars. Assume that the current exchange rate for the Canadian dollar (C$) is $.73 and that Weber expects to receive C$50,000 in 3 months. The following options for Canadian dollars are available.

E X A M P L E

• Call option 1 premium on Canadian dollars $.015. • Call option 2 premium on Canadian dollars $.008. • Call option 1 strike price $.73. • Call option 2 strike price $.75. • One option contract represents C$50,000. If Weber believes the Canadian dollar will not depreciate much below the lower exercise price of $.75, it can construct a bear spread to hedge the receivable. Weber will buy call option 2 and write call option 1 to establish this bear spread. The total cash inflow resulting from this

Chapter 11: Managing Transaction Exposure

345

In summary, MNCs should hedge receivables using bear spreads only for relatively stable currencies that are expected to depreciate modestly, but not drastically, prior to option expiration.

APPENDIX 11

bear spread is C$50,000 ($.015 $.008) $350. Constructing a bear spread will always result in a net cash inflow, since the spreader writes the call option with the lower exercise price and, therefore, the higher premium. What will happen if the Canadian dollar appreciates above the higher exercise price of $.75 prior to option expiration? For example, assume that the spot rate for the Canadian dollar is $.80 at option expiration. In this case, the bear spread would result in the maximum loss of $.013 ($.75 $.73 $.015 $.008) per Canadian dollar, for a total maximum loss of $650. However, Weber can now sell the receivables at the prevailing spot rate of $.80, netting $39,350 (C$50,000 $.80 $650). Furthermore, while the maximum loss remains at $650 for the bear spread, Weber can benefit if the Canadian dollar appreciates even more. The bear spread also provides an effective hedge if the spot price of the Canadian dollar at option expiration is above the lower strike price of $.73 but below the higher strike price of $.75. In this case, however, the benefit is reduced. For instance, if the spot price at option expiration is $.74, Weber will let option 2 expire. The buyer of option 1 will exercise it, and Weber will sell the receivables at the exercise price of $.73 to fulfill its obligation. This will result in a total cash inflow of $36,850 (C$50,000 $.73 $350) after including the net premium received from establishing the spread. If the Canadian dollar depreciates below the lower strike price of $.73, Weber will realize the maximum gain from the bear spread but will have to sell the receivables at the low prevailing spot rate. For example, if the spot rate at option expiration is $.70, both options will expire worthless, but Weber would have received $350 from establishing the spread. If Weber sells the receivables at the spot rate, the net cash inflow will be $35,350 (C$50,000 $.70 $350). ■

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12: Managing Economic Exposure and Translation Exposure As the previous chapter described, MNCs can manage the exposure of their international transactions to exchange rate movements (referred to as transaction exposure) in various ways. Nevertheless, cash ﬂows of MNCs may still be sensitive to exchange rate movements (economic exposure) even if anticipated international transactions are hedged. Furthermore, the consolidated ﬁnancial statements of MNCs may still be exposed to exchange rate movements (translation exposure). By managing economic exposure and translation exposure, ﬁnancial managers may increase the value of their MNCs.

The specific objectives of this chapter are to: ■ explain how an MNC’s economic exposure can be

hedged, and ■ explain how an MNC’s translation exposure can be

hedged. In general, it is more difﬁcult to effectively hedge economic or translation exposure than to hedge transaction exposure, for reasons explained in this chapter.

Economic Exposure From a U.S. ﬁ rm’s perspective, transaction exposure represents only the exchange rate risk when converting net foreign cash inﬂows to U.S. dollars or when purchasing foreign currencies to send payments. Economic exposure represents any impact of exchange rate ﬂuctuations on a ﬁ rm’s future cash ﬂows. Corporate cash ﬂows can be affected by exchange rate movements in ways not directly associated with foreign transactions. Thus, ﬁ rms cannot focus just on hedging their foreign currency payables or receivables but must also attempt to determine how all their cash ﬂows will be affected by possible exchange rate movements. Nike’s economic exposure comes in various forms. First, it is subject to transaction exposure because of its numerous purchase and sale transactions in foreign currencies, and this transaction exposure is a subset of economic exposure. Second, any remitted earnings from foreign subsidiaries to the U.S. parent also reflect transaction exposure and therefore reflect economic exposure. Third, a change in exchange rates that affects the demand for shoes at other athletic shoe companies (such as Adidas) can indirectly affect the demand for Nike’s athletic shoes. Nike attempts to hedge some of its transaction exposure, but it cannot eliminate transaction exposure because it cannot predict all future transactions. Moreover, even if it could eliminate its transaction exposure, it cannot perfectly hedge its remaining economic exposure; it is difficult to determine exactly how a specific exchange rate movement will affect the demand for a competitor’s athletic shoes and, therefore, how it will indirectly affect the demand for Nike’s shoes. ■

E X A M P L E

The following comments by PepsiCo summarize the dilemma faced by many MNCs that assess economic exposure.

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Chapter 12: Managing Economic Exposure and Translation Exposure

H T T P : // http://www.ibm.com/us/ An example of an MNC’s website. The websites of various MNCs make available ﬁnancial statements such as annual reports that describe the use of ﬁnancial derivatives to hedge interest rate risk and exchange rate risk.

347

The economic impact of currency exchange rates on us is complex because such changes are often linked to variability in real growth, infl ation, interest rates, governmental actions, and other factors. These changes, if material, can cause us to adjust our fi nancing and operating strategies. —PepsiCo

Use of Projected Cash Flows to Assess Economic Exposure An MNC must determine its economic exposure before it can manage its exposure. It can determine its exposure to each currency in terms of its cash inﬂows and cash outﬂows. Information for each subsidiary can be used to derive estimates. Recall from Chapter 10 that Madison Co. is subject to economic exposure. Madison can assess its economic exposure to exchange rate movements by determining the sensitivity of its expenses and revenue to various possible exchange rate scenarios. Exhibit 12.1 reproduces Madison’s revenue and expense information from Exhibit 10.9 of Chapter 10. Madison’s sales in the United States are not sensitive to exchange rate scenarios. Canadian sales are expected to be C$4 million, but the dollar amount received from these sales will depend on the scenario. The cost of materials purchased in the United States is assumed to be $50 million and insensitive to exchange rate movements. The cost of materials purchased in Canada is assumed to be C$200 million. The U.S. dollar amount of this cost varies with the exchange rate scenario. The interest owed to U.S. banks is insensitive to the exchange rate scenario, but the projected amount of dollars needed to pay interest on existing Canadian loans varies with the exchange rate scenario.

E X A M P L E

Exhibit 12.1

Original Impact of Possible Exchange Rates on Cash Flows of Madison Co. (in Millions) Exchange Rate Scenario C$1 $.75

C$1 $.80

C$1 .85

Sales (1) U.S. sales (2) Canadian sales

$320.00 C$4

(3) Total sales in U.S. $

3.00

$320.00 C$4

3.20

$320.00 C$4

3.40

$323.00

$323.20

$323.40

$ 50.00

$ 50.00

$ 50.00

Cost of Materials (4) U.S. cost of materials (5) Canadian cost of materials

C$200

150.00

C$200

160.00

C$200

170.00

(6) Total cost of materials in U.S. $

$200.00

$210.00

$220.00

(7) Operating expenses

$ 60.00

$ 60.00

$ 60.00

$

$

$

Interest Expenses (8) U.S. interest expenses (9) Canadian interest expenses

C$10

3 7.5

C$10

3 8

C$10

3 8.50

(10) Total interest expenses in U.S. $

$ 10.5

$ 11

$ 11.50

Cash ﬂows in U.S. dollars before taxes

$ 52.50

$ 42.20

$ 31.90

348

Part 3: Exchange Rate Risk Management Exhibit 12.1 enables Madison to assess how its cash flows before taxes will be affected by different exchange rate movements. A stronger Canadian dollar increases Madison’s dollar revenue earned from Canadian sales. However, it also increases Madison’s cost of materials purchased from Canada and the dollar amount needed to pay interest on loans from Canadian banks. The higher expenses more than offset the higher revenue in this scenario. Thus, the amount of Madison’s cash flows before taxes is inversely related to the strength of the Canadian dollar. If the Canadian dollar strengthens consistently over the long run, Madison’s expenses likely will rise at a higher rate than its U.S. dollar revenue. Consequently, it may wish to institute some policies to ensure that movements of the Canadian dollar will have a more balanced impact on its revenue and expenses. Now that Madison has assessed its exposure, it recognizes that it can reduce this exposure by either increasing Canadian sales or reducing orders of Canadian materials. These actions would allow some offsetting of cash flows and therefore reduce its economic exposure, as explained next. ■

How Restructuring Can Reduce Economic Exposure MNCs may restructure their operations to reduce their economic exposure. The restructuring involves shifting the sources of costs or revenue to other locations in order to match cash inﬂows and outﬂows in foreign currencies. Reconsider the previous example of Madison Co., which has more cash outflows than cash inflows in Canadian dollars. Madison could create more balance by increasing Canadian sales. It believes that it can achieve Canadian sales of C$20 million if it spends $2 million more on advertising (which is part of Madison’s operating expenses). The increased sales will also require an additional expenditure of $10 million on materials from U.S. suppliers. In addition, it plans to reduce its reliance on Canadian suppliers and increase its reliance on U.S. suppliers. Madison anticipates that this strategy will reduce the cost of materials from Canadian suppliers by C$100 million and increase the cost of materials from U.S. suppliers by $80 million (not including the $10 million increase resulting from increased sales to the Canadian market). Furthermore, it plans to borrow additional funds in the United States and retire some existing loans from Canadian banks. The result will be an additional interest expense of $4 million to U.S. banks and a reduction of C$5 million owed to Canadian banks. Exhibit 12.2 shows the anticipated impact of these strategies on Madison’s cash flows. For each of the three exchange rate scenarios, the initial projections are in the left column, and the revised projections (as a result of the proposed strategy) are in the right column. Note first that the projected total sales increase in response to Madison’s plan to penetrate the Canadian market (see row 2). Second, the U.S. cost of materials is now $90 million higher as a result of the $10 million increase to accommodate increased Canadian sales and the $80 million increase due to the shift from Canadian suppliers to U.S. suppliers (see row 4). The Canadian cost of materials decreases from C$200 million to C$100 million as a result of this shift (see row 5). The revised operating expenses of $62 million include the $2 million increase in advertising expenses necessary to penetrate the Canadian market (see row 7). The interest expenses are revised because of the increased loans from the U.S. banks and reduced loans from Canadian banks (see rows 8 and 9). If Madison increases its Canadian dollar inflows and reduces its Canadian dollar outflows as proposed, its revenue and expenses will be affected by movements of the Canadian dollar in a somewhat similar manner. Thus, its performance will be less susceptible to movements in the Canadian dollar. Exhibit 12.3 illustrates the sensitivity of Madison’s earnings before taxes to the three exchange rate scenarios (derived from Exhibit 12.2). The reduced sensitivity of Madison’s proposed restructured operations to exchange rate movements is obvious. ■

E X A M P L E

Exhibit 12.2

Impact of Possible Exchange Rate Movements on Earnings under Two Alternative Operational Structures (in Millions) Exchange Rate Scenario C$ $.75

Exchange Rate Scenario C$ $.80

Original Operational Structure

Proposed Operational Structure

Original Operational Structure

$320.0

$320.00

$320.00

Proposed Operational Structure

Exchange Rate Scenario C$ $.85 Original Operational Structure

Proposed Operational Structure

$320.00

$320.00

Sales (1) U.S. sales (2) Canadian sales

C$4

(3) Total sales in U.S. $

3.0

C$20

15.00

C$4

3.20

$320 C$20

16

C$4

3.40

C$20

17.00

$323.0

$335.00

$323.20

$336

$323.40

$337.00

$ 50.0

$140.00

$ 50.00

$140

$ 50.00

$140.00

Cost of Materials (4) U.S. cost of materials (5) Canadian cost of materials

C$200 150.0

(6) Total cost of materials in U.S. $

C$100

75.00

C$200

160.00

C$100

80

C$200

170.00

C$100

85.00

$200.0

$215.00

$210.00

$220

$220.00

$225.00

$ 60

$ 62

$ 60

$ 62

$ 60

$ 62

3.00

$

$ 3.00

$ 7.00

(7) Operating expenses Interest Expenses (8) U.S. interest expenses (9) Canadian interest expenses

$ C$10

3.0 7.5

$ C$5

7.00 3.75

$ C$10

8.00

C$5

7 4

C$10

8.50

C$5

4.25

(10) Total interest expenses in U.S. $

$ 10.5

$ 10.75

$ 11.00

$ 11

$ 11.50

$ 11.25

(11) Cash ﬂows in U.S. dollars before taxes

$ 52.5

$ 47.25

$ 42.2

$ 43

$ 31.9

$ 38.75

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Part 3: Exchange Rate Risk Management

The way a ﬁ rm restructures its operations to reduce economic exposure to exchange rate risk depends on the form of exposure. For Madison Co. future expenses

are more sensitive than future revenue to the possible values of a foreign currency. Therefore, it can reduce its economic exposure by increasing the sensitivity of revenue and reducing the sensitivity of expenses to exchange rate movements. Firms that have a greater level of exchange rate–sensitive revenue than expenses, however, would reduce their economic exposure by decreasing the level of exchange rate–sensitive revenue or by increasing the level of exchange rate–sensitive expenses. Some revenue or expenses may be more sensitive to exchange rates than others. Therefore, simply matching the level of exchange rate–sensitive revenue to the level of exchange rate–sensitive expenses may not completely insulate a ﬁ rm from exchange rate risk. The ﬁ rm can best evaluate a proposed restructuring of operations by forecasting various items for various possible exchange rate scenarios (as shown in Exhibit 12.2) and then assessing the sensitivity of cash ﬂows to these different scenarios.

Expediting the Analysis with Computer Spreadsheets. Determining the sensitivity of cash ﬂows (ignoring tax effects) to alternative exchange rate scenarios can be expedited by using a computer to create a spreadsheet similar to Exhibit 12.2. By revising the input to reﬂect various possible restructurings, the analyst can determine how each operational structure would affect the ﬁ rm’s economic exposure. Recall that Madison Co. assessed one alternative operational structure in which it increased Canadian sales by C$16 million, reduced its purchases of Canadian materials by C$100 million, and reduced its interest owed to Canadian banks by C$5 million. By using a computerized spreadsheet, Madison can easily assess the impact of alternative strategies, such as increasing Canadian sales by other amounts and/or reducing the Canadian expenses by other amounts. This provides Madison with more information about its economic exposure under various operational structures and enables it to devise the operational structure that will reduce its economic exposure to the degree desired. ■

E X A M P L E

Exhibit 12.3

Economic Exposure Based on the Original and Proposed Operating Structures

$60

Cash Flows

$50 Proposed Operating Structure

$40 $30

Original Operating Structure

$20

C$ = $.75

C$ = $.80 Exchange Rate Scenario

C$ = $.85

Chapter 12: Managing Economic Exposure and Translation Exposure

351

Issues Involved in the Restructuring Decision Restructuring operations to reduce economic exposure is a more complex task than hedging any single foreign currency transaction, which is why managing economic exposure is normally perceived to be more difﬁcult than managing transaction exposure. By managing economic exposure, however, the ﬁ rm is developing a long-term solution because once the restructuring is complete, it should reduce economic exposure over the long run. In contrast, the hedging of transaction exposure deals with each upcoming foreign currency transaction separately. Note, however, that it can be very costly to reverse or eliminate restructuring that was undertaken to reduce economic exposure. Therefore, MNCs must be very conﬁdent about the potential beneﬁts before they decide to restructure their operations. When deciding how to restructure operations to reduce economic exposure, one must address the following questions: • Should the ﬁ rm attempt to increase or reduce sales in new or existing foreign markets? • Should the ﬁ rm increase or reduce its dependency on foreign suppliers? • Should the ﬁ rm establish or eliminate production facilities in foreign markets? • Should the ﬁ rm increase or reduce its level of debt denominated in foreign currencies? The ﬁ rst question relates to foreign cash inﬂows and the remaining ones to foreign cash outﬂows. Some of the more common solutions to balancing a foreign currency’s inﬂows and outﬂows are summarized in Exhibit 12.4. Any restructuring of operations that can reduce the periodic difference between a foreign currency’s inﬂows and outﬂows can reduce the ﬁ rm’s economic exposure to that currency’s movements. MNCs that have production and marketing facilities in various countries may be able to reduce any adverse impact of economic exposure by shifting the allocation of their operations. Deland Co. produces products in the United States, Japan, and Mexico and sells these products (denominated in the currency where they are produced) to several countries. If the Japanese yen strengthens against many currencies, Deland may boost production in Mexico, expecting a decline in demand for the Japanese subsidiary’s products. Deland may even transfer some machinery from Japan to Mexico and allocate more marketing funds to the Mexican subsidiary at the expense of the Japanese subsidiary. By following this strategy, however, Deland may have to forgo economies of scale that could be achieved if it concentrated production at one subsidiary while other subsidiaries focused on warehousing and distribution. ■

E X X A M P L E

Exhibit 12.4 How to Restructure Operations to Balance the Impact of Currency Movements on Cash Inﬂows and Outﬂows

Type of Operation

Recommended Action When a Foreign Currency Has a Greater Impact on Cash Inﬂows

Recommended Action When a Foreign Currency Has a Greater Impact on Cash Outﬂows

Sales in foreign currency units

Reduce foreign sales

Increase foreign sales

Reliance on foreign supplies

Increase foreign supply orders

Reduce foreign supply orders

Proportion of debt structure representing foreign debt

Restructure debt to increase debt payments in foreign currency

Restructure debt to reduce debt payments in foreign currency

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Part 3: Exchange Rate Risk Management

A Case Study in Hedging Economic Exposure In reality, most MNCs are not able to reduce their economic exposure as easily as Madison Co. in the previous example. First, an MNC’s economic exposure may not be so obvious. An analysis of the income statement for an entire MNC may not necessarily detect its economic exposure. The MNC may be composed of various business units, each of which attempts to achieve high performance for its shareholders. Each business unit may have a unique cost and revenue structure. One unit of an MNC may focus on computer consulting services in the United States and have no exposure to exchange rates. Another unit may also focus on sales of personal computers in the United States, but this unit may be adversely affected by weak foreign currencies because its U.S. customers may buy computers from foreign ﬁ rms. Although the MNC is mostly concerned with the effect of exchange rates on its performance and value overall, it can more effectively hedge its economic exposure if it can pinpoint the underlying source of the exposure. Yet, even if the MNC can pinpoint the underlying source of the exposure, there may not be a perfect hedge against that exposure. No textbook formula can provide the perfect solution, but a combination of actions may reduce the economic exposure to a tolerable level, as illustrated in the following example. This example is more difﬁcult than the previous example of Madison Co., but it may be more realistic for many MNCs.

Savor Co.’s Dilemma Savor Co., a U.S. ﬁ rm, is primarily concerned with its exposure to the euro. It wants to pinpoint the source of its exposure so that it can determine how to hedge its exposure. Savor has three units that conduct some business in Europe. Because each unit has established a wide variety of business arrangements, it is not obvious whether all three units have a similar exposure. Each unit tends to be independent of the others, and the managers of each unit are compensated according to that unit’s performance. Savor may want to hedge its economic exposure, but it must ﬁ rst determine whether it is exposed and the source of the exposure.

Assessment of Economic Exposure Because the exact nature of its economic exposure to the euro is not obvious, Savor attempts to assess the relationship between the euro’s movements and each unit’s cash ﬂows over the last nine quarters. A ﬁ rm may want to use more data, but nine quarters are sufﬁcient to illustrate the point. The cash ﬂows and movements in the euro are shown in Exhibit 12.5. First, Savor applies regression analysis (as discussed in the previous chapter) to determine whether the percentage change in its total cash ﬂow (PCF, shown in column 5) is related to the percentage change in the euro (%Deuro, shown in column 6) over time: PCFt a 0 a1(%Deuro)t mt Regression analysis derives the values of the constant, a 0, and the slope coefﬁcient, a1. The slope coefﬁcient represents the sensitivity of PCFt to movements in the euro. Based on this analysis, the slope coefﬁcient is positive and statistically signiﬁcant, which implies that the cash ﬂows are positively related to the percentage changes in the euro. That is, a negative change in the euro adversely affects Savor’s total cash ﬂows. The R-squared statistic is .31, which suggests that 31 percent of the variation in Savor’s cash ﬂows can be explained by movements in the euro. The evidence presented so far strongly suggests that Savor is exposed to exchange rate movements of the euro but does not pinpoint the source of the exposure.

Chapter 12: Managing Economic Exposure and Translation Exposure Exhibit 12.5 (1)

Quarter

353

Assessment of Savor Co.’s Cash Flows and the Euro’s Movements

(2) % Change in Unit A’s Cash Flows

(3) (4) % Change in % Change in Unit B’s Unit C’s Cash Flows Cash Flows

(5) % Change in Total Cash Flows

(6) % Change in the Value of the Euro

1

3

2

1

0

2

2

0

1

3

4

5

3

6

6

1

1

3

4

1

1

1

1

0

5

4

0

1

5

2

6

1

2

2

5

5

7

1

3

3

1

4

8

3

2

1

0

2

9

4

1

0

3

4

Assessment of Each Unit’s Exposure To determine the source of the exposure, Savor applies the regression model separately to each individual unit’s cash ﬂows. The results are shown here (apply the regression analysis yourself as an exercise):

Unit

Slope Coefﬁcient

A

Not signiﬁcant

B

Not signiﬁcant

C

Coefﬁcient .45, which is statistically signiﬁcant (R-squared .80)

The results suggest that the cash ﬂows of Units A and B are not subject to economic exposure. However, Unit C is subject to economic exposure. Approximately 80 percent of Unit C’s cash ﬂows can be explained by movements in the value of the euro over time. The regression coefﬁcient suggests that for a 1 percent decrease in the value of the euro, the unit’s cash ﬂows will decline by about .45 percent. Exhibit 12.5, which shows the euro’s exchange rate movements and the cash ﬂows for Savor’s individual units, conﬁ rms the strong relationship between the euro’s movements and Unit C’s cash ﬂows.

Identifying the Source of the Unit’s Exposure Now that Savor has determined that one unit is the cause of the exposure, it can pinpoint the characteristics of that unit that cause the exposure. Savor believes that the key components that affect Unit C’s cash ﬂows are income statement items such as its U.S. revenue, its cost of goods sold, and its operating expenses. This unit conducts all of its production in the United States. Savor ﬁ rst determines the value of each income statement item that affected the unit’s cash ﬂows in each of the last nine quarters. It then applies regression analysis to

354

Part 3: Exchange Rate Risk Management

determine the relationship between the percentage change in the euro and each income statement item over those quarters. Assume that it ﬁ nds: • A signiﬁcant positive relationship between Unit C’s revenue and the euro’s value. • No relationship between the unit’s cost of goods sold and the euro’s value. • No relationship between the unit’s operating expenses and the euro’s value. These results suggest that when the euro weakens, the unit’s revenue from U.S. customers declines substantially. Its U.S. customers shift their demand to foreign competitors when the euro weakens and they can obtain imports at a low price. Thus, Savor’s economic exposure could be due to foreign competition. A ﬁ rm’s economic exposure is not always obvious, however, and regression analysis may detect exposure that was not suspected by the ﬁ rm or its individual units. Furthermore, regression analysis can be used to provide a more precise estimate of the degree of economic exposure, which can be useful when deciding how to manage the exposure.

Possible Strategies to Hedge Economic Exposure Now that Savor has identiﬁed the source of its economic exposure, it can develop a strategy to reduce that exposure.

Pricing Policy. Savor recognizes that there will be periods in the future when the euro will depreciate against the dollar. Under these conditions, Unit C may attempt to be more competitive by reducing its prices. If the euro’s value declines by 10 percent and this reduces the prices that U.S. customers pay for the foreign products by 10 percent, then Unit C can attempt to remain competitive by discounting its prices by 10 percent. Although this strategy can retain market share, the lower prices will result in less revenue and therefore less cash ﬂ ows. Therefore, this strategy does not completely eliminate Savor’s economic exposure. Nevertheless, this strategy may still be feasible, especially if the unit can charge relatively high prices in periods when the euro is strong and U.S. customers have to pay higher prices for European products. In essence, the strategy might allow the unit to generate abnormally high cash ﬂows in a strong-euro period to offset the abnormally low cash ﬂows in a weakeuro period. The adverse effect during a weak-euro period will still occur, however. Given the limitations of this strategy, other strategies should be considered. Hedging with Forward Contracts. Savor’s Unit C could sell euros forward for the period in which it wants to hedge against the adverse effects of the weak euro. Assume the spot and 3-month forward rates on the euro are $1. If the euro weakens, the cash ﬂows from normal operations will still be adversely affected. However, the unit would generate a gain on the forward contract because it will be able to purchase euros at the spot rate at the end of the period at a lower exchange rate than the rate at which it will have to sell those euros to fulﬁ ll the forward contract. The weaker the euro, the more pronounced will be the adverse effects on the unit’s cash ﬂows from normal operations, but the gains from the forward contract will also be more pronounced. Using a forward contract has deﬁ nite limitations, however. Since the economic exposure is likely to continue indeﬁ nitely, the use of a forward contract in the manner described here hedges only for the period of the contract. It does not serve as a continuous long-term hedge against economic exposure. Purchasing Foreign Supplies. Another possibility is for the unit to purchase its materials in Europe, a strategy that would reduce its costs (and enhance its cash ﬂows) during a weak-euro period to offset the adverse effects of the weak

Chapter 12: Managing Economic Exposure and Translation Exposure

355

euro. However, the cost of buying European materials may be higher than the cost of buying local materials, especially when transportation expenses are considered.

Financing with Foreign Funds. The unit could also reduce its economic exposure by ﬁ nancing a portion of its business with loans in euros. It could convert the loan proceeds to dollars and use the dollars to support its business. It will need to make periodic loan repayments in euros. If the euro weakens, the unit will need fewer dollars to cover the loan repayments. This favorable effect can partially offset the adverse effect of a weak euro on the unit’s revenue. If the euro strengthens, the unit will need more dollars to cover the loan repayments, but this adverse effect will be offset by the favorable effect of the strong euro on the unit’s revenue. This type of hedge is more effective than the pricing hedge because it can offset the adverse effects of a weak euro in the same period (whereas the pricing policy attempts to make up for lost cash ﬂows once the euro strengthens). This strategy also has some limitations. First, the strategy only makes sense if Savor needs some debt ﬁ nancing. It should not borrow funds just for the sake of hedging its economic exposure. Second, Savor might not desire this strategy when the euro has a very high interest rate. Though borrowing in euros can reduce its economic exposure, it may not be willing to enact the hedge at a cost of higher interest expenses than it would pay in the United States. Third, this strategy is unlikely to create a perfect hedge against Savor’s economic exposure. Even if the company needs debt ﬁ nancing and the interest rate charged on the foreign loan is low, Savor must attempt to determine the amount of debt ﬁ nancing that will hedge its economic exposure. The amount of foreign debt ﬁ nancing necessary to fully hedge the exposure may exceed the amount of funding that Savor needs.

Revising Operations of Other Units. Given the limitations of hedging Unit C’s economic exposure by adjusting the unit’s operations, Savor may consider modifying the operations of another unit in a manner that will offset the exposure of Unit C. However, this strategy may require changes in another unit that will not necessarily beneﬁt that unit. For example, assume that Unit C could partially hedge its economic exposure by borrowing euros (as explained above) but that it does not need to borrow as much as would be necessary to fully offset its economic exposure. Savor’s top management may suggest that Units A and B also obtain their ﬁ nancing in euros, so that the MNC’s overall economic exposure is hedged. Thus, a weak euro would still adversely affect Unit C because the adverse effect on its revenue would not be fully offset by the favorable effect on its ﬁ nancing (debt repayments). Yet, if the other units have borrowed euros as well, the combined favorable effects on ﬁ nancing for Savor overall could offset the adverse effects on Unit C. However, Units A and B will not necessarily desire to ﬁ nance their operations in euros. Recall that these units are not subject to economic exposure. Also recall that the managers of each unit are compensated according to the performance of that unit. By agreeing to ﬁ nance in euros, Units A and B could become exposed to movements in the euro. If the euro strengthens, their cost of ﬁ nancing increases. So, by helping to offset the exposure of Unit C, Units A and B could experience weaker performance, and their managers would receive less compensation. A solution is still possible if Savor’s top managers who are not afﬁ liated with any unit can remove the hedging activity from the compensation formula for the units’ managers. That is, top management could instruct Units A and B to borrow funds in euros, but could reward the managers of those units based on an assessment of the units’ performance that excludes the effect of the euro on ﬁ nancing costs. In this way, the managers will be more willing to engage in a strategy that increases their economic exposure while reducing Savor’s.

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Part 3: Exchange Rate Risk Management

Savor’s Hedging Solution In summary, Savor’s initial analysis of its units determined that only Unit C was highly subject to economic exposure. Unit C could attempt to use a pricing policy that would maintain market share when the euro weakens, but this strategy would not eliminate the economic exposure because its cash ﬂows would still be adversely affected. Borrowing euros can be an effective strategy to hedge Unit C’s exposure, but it does not need to borrow the amount of funds necessary to offset its exposure. The optimal solution for Savor Co. is to instruct its other units to do their ﬁ nancing in euros as well. This strategy effectively increases their exposure, but in the opposite manner of Unit C’s exposure, so that the MNC’s economic exposure overall is reduced. The units’ managers should be willing to cooperate if their compensation is not reduced as a result of increasing the exposure of their individual units.

Limitations of Savor’s Optimal Hedging Strategy Even if Savor Co. is able to achieve the hedge described above, the hedge will still not be perfect. The impact of the euro’s movements on Savor’s cash outﬂows needed to repay the loans is known with certainty. But the impact of the euro’s movements on Savor’s cash inﬂows (revenue) is uncertain and can change over time. If the amount of foreign competition increases, the sensitivity of Unit C’s cash ﬂows to exchange rates would increase. To hedge this increased exposure, it would need to borrow a larger amount of euros. An MNC’s economic exposure can change over time in response to shifts in foreign competition or other global conditions, so it must continually assess and manage its economic exposure.

Hedging Exposure to Fixed Assets Up to this point, the focus has been on how economic exposure can affect periodic cash ﬂows. The effects may extend beyond periodic cash ﬂows, however. When an MNC has ﬁ xed assets (such as buildings or machinery) in a foreign country, the dollar cash ﬂows to be received from the ultimate sale of these assets is subject to exchange rate risk. Wagner Co., a U.S. firm, pursued a 6-year project in Russia. It purchased a manufacturing plant from the Russian government 6 years ago for 500 million rubles. Since the ruble was worth $.16 at the time of the investment, Wagner needed $80 million to purchase the plant. The Russian government guaranteed that it would repurchase the plant for 500 million rubles in 6 years when the project was completed. At that time, however, the ruble was worth only $.034, so Wagner received only $17 million (computed as 500 million $.034) from selling the plant. Even though the price of the plant in rubles at the time of the sale was the same as the price at the time of the purchase, the sales price of the plant in dollars at the time of the sale was about 79 percent less than the purchase price. ■

E X A M P L E

Some MNCs may not worry about the exchange rate effect on ﬁ xed assets because they normally expect to retain the assets for several years. Given the frequent restructuring of global operations, however, MNCs should consider hedging against the possible sale of these assets in the distant future. A sale of ﬁ xed assets can be hedged by creating a liability that matches the expected value of the assets at the point in the future when they may be sold. In essence, the sale of the ﬁ xed assets generates a foreign currency cash inﬂow that can be used to pay off the liability that is denominated in the same currency.

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357

In the previous example, Wagner could have financed part of its investment in the Russian manufacturing plant by borrowing rubles from a local bank, with the loan structured to have zero interest payments and a lump-sum repayment value equal to the expected sales price set for the date when Wagner expected to sell the plant. Thus, the loan could have been structured to have a lump-sum repayment value of 500 million rubles in 6 years. ■

E X A M P L E

The limitations of hedging a sale of ﬁ xed assets are that an MNC does not necessarily know the (1) date when it will sell the assets or (2) the price in local currency at which it will sell them. Consequently, it is unable to create a liability that perfectly matches the date and amount of the sale of the ﬁ xed assets. Nevertheless, these limitations should not prevent a ﬁ rm from hedging. Even if the Russian government would not guarantee a purchase price of the plant, Wagner Co. could create a liability that reflects the earliest possible sales date and the lowest expected sales price. If the sales date turns out to be later than the earliest possible sales date, Wagner might be able to extend its loan period to match the sales date. By structuring the lump-sum loan repayment to match the minimum sales price, Wagner will not be perfectly hedged if the fixed assets turn out to be worth more than the minimum expected amount. Nevertheless, Wagner would at least have reduced its exposure by offsetting a portion of the fixed assets with a liability in the same currency. ■

E X A M P L E

Long-term forward contracts may also be a possible way to hedge the distant sale of ﬁ xed assets in foreign countries, but they may not be available for many emerging market currencies.

Managing Translation Exposure Translation exposure occurs when an MNC translates each subsidiary’s ﬁ nancial data to its home currency for consolidated ﬁ nancial statements. Even if translation exposure does not affect cash ﬂows, it is a concern of many MNCs because it can reduce an MNC’s consolidated earnings and thereby cause a decline in its stock price. Thus, some MNCs may consider hedging their translation exposure. Columbus Co. is a U.S.-based MNC with a subsidiary in the United Kingdom. The subsidiary typically accounts for about half of the total revenue and earnings generated by Columbus. In the last three quarters, the value of the British pound declined, and the reported dollar level of earnings attributable to the British subsidiary was weak simply because of the relatively low rate at which the British earnings were translated into U.S. dollars. During this period, some stock analysts who follow Columbus reduced their rating of Columbus stock. This downgrade in the rating resulted in a lower stock price because many investors rely on ratings when deciding what stocks to buy or sell. The high-level managers and the board were criticized in the media for poor performance, even though the only reason for the poor performance was the translation effect on earnings. The compensation levels are tied to consolidated earnings and therefore were low this year because of the translation effect. Consequently, Columbus decided that it would attempt to hedge translation exposure in the future. ■

E X A M P L E

Use of Forward Contracts to Hedge Translation Exposure MNCs can use forward contracts or futures contracts to hedge translation exposure. Speciﬁcally, they can sell the currency forward that their foreign subsidiaries receive as earnings. In this way, they create a cash outﬂow in the currency to offset the earnings received in that currency.

358

Part 3: Exchange Rate Risk Management Recall that Columbus Co. has one subsidiary based in the United Kingdom. While there is no foreseeable transaction exposure in the near future from the future earnings (since the pounds will remain in the United Kingdom), Columbus is exposed to translation exposure. The subsidiary forecasts that its earnings next year will be £20 million. To hedge its translation exposure, Columbus can implement a forward hedge on the expected earnings by selling £20 million one year forward. Assume the forward rate at that time is $1.60, the same as the spot rate. At the end of the year, Columbus can buy £20 million at the spot rate and fulfill its forward contract obligation to sell £20 million. If the pound depreciates during the fiscal year, then Columbus will be able to purchase pounds at the end of the fiscal year to fulfill the forward contract at a cheaper rate than it can sell them ($1.60 per pound). Thus, it will have generated income that can offset the translation loss. If the pound depreciates over the year such that the average weighted exchange rate is $1.50 over the year, the subsidiary’s earnings will be translated as follows:

E X A M P L E

Translated earnings 5 Subsidiary earnings 3 Weighted average exchange rate 5 20 million pounds 3 $1.50 5 $30 million If the exchange rate had not declined over the year, the translated amount of earnings would have been $32 million (computed as 20 million pounds $1.60), so the exchange rate movements caused the reported earnings to be reduced by $2 million. However, there is a gain from the forward contract because the spot rate declined over the year. If we assume that the spot rate is worth $1.50 at the end of the year, then the gain on the forward contract would be:

Gain on forward contract 5 1 Amount received from forward sale 2 2 1 Amount paid to fulfill forward contract obligation 2 1 5 20 million pounds 3 $1.60 2 2 1 20 million pounds 3 $1.50 2 5 $32 million 2 $30 million 5 $2 million

■

In the preceding example, the dollar amount of the gain on the forward contract exactly offsets the reduction in reported earnings due to the translation effect. That is because we assumed that the spot rate at the end of the year was the same as the weighted average exchange rate over the year. In reality, a perfect offsetting effect is unlikely. However, when there is a relatively large reduction in the weighted average exchange rate, there will likely be a large reduction in the spot rate over that same period. Consequently, the larger the adverse translation effect, the larger the gain on the forward contract. Thus, the forward contract is normally effective in hedging a portion of the translation exposure.

Limitations of Hedging Translation Exposure There are four limitations in hedging translation exposure.

Inaccurate Earnings Forecasts. A subsidiary’s forecasted earnings for the end of the year are not guaranteed. In the previous example involving Columbus, Inc., British earnings were projected to be £20 million. If the actual earnings turned out to be much higher, and if the pound weakens during the year, the translation loss would likely exceed the gain generated from the forward contract strategy. Inadequate Forward Contracts for Some Currencies. A second limitation is that forward contracts are not available for all currencies. Thus, an

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359

MNC with subsidiaries in some smaller countries may not be able to obtain forward contracts for the currencies of concern.

Accounting Distortions. A third limitation is that the forward rate gain or loss reﬂects the difference between the forward rate and the future spot rate, whereas the translation gain or loss is caused by the change in the average exchange rate over the period in which the earnings are generated. In addition, the translation losses are not tax deductible, whereas gains on forward contracts used to hedge translation exposure are taxed. Increased Transaction Exposure. The fourth and most critical limitation with a hedging strategy such as using a forward contract on translation exposure is that the MNC may be increasing its transaction exposure. For example, consider a situation in which the subsidiary’s currency appreciates during the ﬁscal year, resulting in a translation gain. If the MNC enacts a hedge strategy at the start of the ﬁscal year, this strategy will generate a transaction loss that will somewhat offset the translation gain. Some MNCs may not be comfortable with this offsetting effect. The translation gain is simply a paper gain; that is, the reported dollar value of earnings is higher due to the subsidiary currency’s appreciation. If the subsidiary reinvests the earnings, however, the parent does not receive any more income due to this appreciation. The MNC parent’s net cash ﬂow is not affected. Conversely, the loss resulting from a hedge strategy is a real loss; that is, the net cash ﬂow to the parent will be reduced due to this loss. Thus, in this situation, the MNC reduces its translation exposure at the expense of increasing its transaction exposure. Governing the Hedge of Translation Exposure Many managers of an MNC are granted stock options as part of their compensation. They recognize that the MNC’s stock price may change in response to a change in consolidated earnings. They can partially hedge against adverse effects of exchange rate movements on consolidated earnings. To the extent that managers are concerned that any adverse translation effect on consolidated earnings would result in a lower stock price, their own compensation is affected. They may hedge translation exposure to hedge their own exposure to their compensation. In this case, their decisions for the MNC are based on their own situation. An MNC can impose controls to prevent this type of agency problem. For example, it could specify the conditions that are necessary for managers to hedge translation exposure or require board approval. ■

GOVE ER RN NA AN NC CE E

SUMMARY ■ Economic exposure can be managed by balancing the sensitivity of revenue and expenses to exchange rate ﬂuctuations. To accomplish this, however, the ﬁ rm must ﬁ rst recognize how its revenue and expenses are affected by exchange rate ﬂuctuations. For some ﬁ rms, revenue is more susceptible. These ﬁ rms are most concerned that their home currency will appreciate against foreign currencies since the unfavorable effects on revenue will more than offset the

favorable effects on expenses. Conversely, ﬁ rms whose expenses are more sensitive to exchange rates than their revenue are most concerned that their home currency will depreciate against foreign currencies. When ﬁ rms reduce their economic exposure, they reduce not only these unfavorable effects but also the favorable effects if the home currency value moves in the opposite direction.

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Part 3: Exchange Rate Risk Management

■ Translation exposure can be reduced by selling forward the foreign currency used to measure a subsidiary’s income. If the foreign currency depreciates against the home currency, the adverse impact on the consolidated income statement can be offset by the gain on the forward sale in that currency. If

POINT

the foreign currency appreciates over the time period of concern, there will be a loss on the forward sale that is offset by a favorable effect on the reported consolidated earnings. However, many MNCs would not be satisﬁed with a “paper gain” that offsets a “cash loss.”

COUNTER-POINT

Can an MNC Reduce the Impact of Translation Exposure by Communicating? Point Yes. Investors commonly use earnings to derive an MNC’s expected future cash ﬂows. Investors do not necessarily recognize how an MNC’s translation exposure could distort their estimates of the MNC’s future cash ﬂows. Therefore, the MNC could clearly communicate in its annual report and elsewhere how the earnings were affected by translation gains and losses in any period. If investors have this information, they will not overreact to earnings changes that are primarily attributed to translation exposure.

SELF

Counter-Point No. Investors focus on the bottom line and should ignore any communication regarding the translation exposure. Moreover, they may believe that translation exposure should be accounted for anyway. If foreign earnings are reduced because of a weak currency, the earnings may continue to be weak if the currency remains weak. Who Is Correct? Use the Internet to learn more about this issue. Which argument do you support? Offer your own opinion on this issue.

TEST

Answers are provided in Appendix A at the back of the text. 1. Salem Exporting Co. purchases chemicals from U.S. sources and uses them to make pharmaceutical products that are exported to Canadian hospitals. Salem prices its products in Canadian dollars and is concerned about the possibility of the long-term depreciation of the Canadian dollar against the U.S. dollar. It periodically hedges its exposure with short-term forward contracts, but this does not insulate against the possible trend of continuing Canadian dollar depreciation. How could Salem offset some of its exposure resulting from its export business? 2. Using the information in question 1, give a possible disadvantage of offsetting exchange rate exposure from the export business. 3. Coastal Corp. is a U.S. ﬁ rm with a subsidiary in the United Kingdom. It expects that the pound will depreciate this year. Explain Coastal’s translation

exposure. How could Coastal hedge its translation exposure? 4. Arlington Co. has substantial translation exposure in European subsidiaries. The treasurer of Arlington Co. suggests that the translation effects are not relevant because the earnings generated by the European subsidiaries are not being remitted to the U.S. parent, but are simply being reinvested in Europe. Nevertheless, the vice president of ﬁ nance of Arlington Co. is concerned about translation exposure because the stock price is highly dependent on the consolidated earnings, which are dependent on the exchange rates at which the earnings are translated. Who is correct? 5. Lincolnshire Co. exports 80 percent of its total production of goods in New Mexico to Latin American countries. Kalafa Co. sells all the goods it produces in the United States, but it has a subsidiary in Spain that usually generates about 20 percent of its total earnings. Compare the translation exposure of these two U.S. ﬁ rms.

Chapter 12: Managing Economic Exposure and Translation Exposure

QUESTIONS

AND

361

A P P L I CAT I O N S

1. Reducing Economic Exposure. Baltimore, Inc., is a U.S.-based MNC that obtains 10 percent of its supplies from European manufacturers. Sixty percent of its revenues are due to exports to Europe, where its product is invoiced in euros. Explain how Baltimore can attempt to reduce its economic exposure to exchange rate ﬂuctuations in the euro. 2. Reducing Economic Exposure. UVA Co. is a U.S.based MNC that obtains 40 percent of its foreign supplies from Thailand. It also borrows Thailand’s currency (the baht) from Thai banks and converts the baht to dollars to support U.S. operations. It currently receives about 10 percent of its revenue from Thai customers. Its sales to Thai customers are denominated in baht. Explain how UVA Co. can reduce its economic exposure to exchange rate ﬂuctuations. 3. Reducing Economic Exposure. Albany Corp. is a U.S.-based MNC that has a large government contract with Australia. The contract will continue for several years and generate more than half of Albany’s total sales volume. The Australian government pays Albany in Australian dollars. About 10 percent of Albany’s operating expenses are in Australian dollars; all other expenses are in U.S. dollars. Explain how Albany Corp. can reduce its economic exposure to exchange rate ﬂuctuations. 4. Tradeoffs When Reducing Economic Exposure. When an MNC restructures its operations to reduce its economic exposure, it may sometimes forgo economies of scale. Explain. 5. Exchange Rate Effects on Earnings. Explain how a U.S.-based MNC’s consolidated earnings are affected when foreign currencies depreciate. 6. Hedging Translation Exposure. Explain how a ﬁ rm can hedge its translation exposure. 7. Limitations of Hedging Translation Exposure. Bartunek Co. is a U.S.-based MNC that has European subsidiaries and wants to hedge its translation exposure to ﬂuctuations in the euro’s value. Explain some limitations when it hedges translation exposure.

supplies (produced in the United States) to customers throughout Latin America. Both subsidiaries purchase the products at cost and sell the products at 90 percent markup. The other operating costs of the subsidiaries are very low. Carlton Co. has a research and development center in the United States that focuses on improving its medical technology. Palmer, Inc., has a similar center based in Mexico. The parent of each ﬁ rm subsidizes its respective research and development center on an annual basis. Which ﬁ rm is subject to a higher degree of economic exposure? Explain. 10. Comparing Degrees of Translation Exposure. Nelson Co. is a U.S. ﬁ rm with annual export sales to Singapore of about S$800 million. Its main competitor is Mez Co., also based in the United States, with a subsidiary in Singapore that generates about S$800 million in annual sales. Any earnings generated by the subsidiary are reinvested to support its operations. Based on the information provided, which ﬁ rm is subject to a higher degree of translation exposure? Explain. Advanced Questions 11. Managing Economic Exposure. St. Paul Co. does business in the United States and New Zealand. In attempting to assess its economic exposure, it compiled the following information. a. St. Paul’s U.S. sales are somewhat affected by the

value of the New Zealand dollar (NZ$), because it faces competition from New Zealand exporters. It forecasts the U.S. sales based on the following three exchange rate scenarios:

Exchange Rate of NZ$

Revenue from U.S. Business (in millions)

NZ$ $.48

$100

NZ$ .50

105

NZ$ .54

110

8. Effective Hedging of Translation Exposure. Would a more established MNC or a less established MNC be better able to effectively hedge its given level of translation exposure? Why?

b. Its New Zealand dollar revenues on sales to New

9. Comparing Degrees of Economic Exposure. Carlton Co. and Palmer, Inc., are U.S.-based MNCs with subsidiaries in Mexico that distribute medical

$200 million from the purchase of U.S. materials and NZ$100 million from the purchase of New Zealand materials.

Zealand invoiced in New Zealand dollars are expected to be NZ$600 million. c. Its anticipated cost of materials is estimated at

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Part 3: Exchange Rate Risk Management d. Fixed operating expenses are estimated at $30

million. e. Variable operating expenses are estimated at

20 percent of total sales (after including New Zealand sales, translated to a dollar amount). f. Interest expense is estimated at $20 million on

existing U.S. loans, and the company has no existing New Zealand loans. Forecast net cash ﬂows for St. Paul Co. under each of the three exchange rate scenarios. Explain how St. Paul’s net cash ﬂows are affected by possible exchange rate movements. Explain how it can restructure its operations to reduce the sensitivity of its net cash ﬂows to exchange rate movements without reducing its volume of business in New Zealand. 12. Assessing Economic Exposure. Alaska, Inc., plans to create and ﬁ nance a subsidiary in Mexico that produces computer components at a low cost and exports them to other countries. It has no other international business. The subsidiary will produce computers and export them to Caribbean islands and will invoice the products in U.S. dollars. The values of the currencies in the islands are expected to remain very stable against the dollar. The subsidiary will pay wages, rent, and other operating costs in Mexican pesos. The subsidiary will remit earnings monthly to the parent. a. Would Alaska’s cash ﬂows be favorably or un-

favorably affected if the Mexican peso depreciates over time? b. Assume that Alaska considers partial ﬁ nancing of

this subsidiary with peso loans from Mexican banks instead of providing all the ﬁ nancing with its own funds. Would this alternative form of ﬁ nancing increase, decrease, or have no effect on the degree to which Alaska is exposed to exchange rate movements of the peso? 13. Hedging Continual Exposure. Clearlake, Inc., produces its products in its factory in Texas and exports most of the products to Mexico each month. The exports are denominated in pesos. Clearlake recognizes that hedging on a monthly basis does not really protect against long-term movements in exchange rates. It also recognizes that it could eliminate its transaction exposure by denominating the exports in dollars, but that it still would have economic exposure (because Mexican consumers would reduce demand if the peso weakened). Clearlake does not know how many pesos it will receive in the future, so it would have difﬁculty even if a long-term hedging method was available. How can Clearlake realistically deal with this dilemma

and reduce its exposure over the long term? (There is no perfect solution, but in the real world, there rarely are perfect solutions.) 14. Sources of Supplies and Exposure to Exchange Rate Risk. Laguna Co. (a U.S. ﬁ rm) will be receiving 4 million British pounds in one year. It will need to make a payment of 3 million Polish zloty in one year. It has no other exchange rate risk at this time. However, it needs to buy supplies and can purchase them from Switzerland, Hong Kong, Canada, or Ecuador. Another alternative is that it could also purchase one-fourth of the supplies from each of the four countries mentioned in the previous sentence. The supplies will be invoiced in the currency of the country from which they are imported. Laguna Co. believes that none of the sources of the imports would provide a clear cost advantage. As of today, the dollar cost of these supplies would be about $6 million regardless of the source that will provide the supplies. The spot rates today are as follows: British pound $1.80 Swiss franc $.60 Polish zloty $.30 Hong Kong dollar $.14 Canadian dollar $.60 The movements of the pound and the Swiss franc and the Polish zloty against the dollar are highly correlated. The Hong Kong dollar is tied to the U.S. dollar, and you expect that it will continue to be tied to the dollar. The movements in the value of the Canadian dollar against the U.S. dollar are not correlated with the movements of the other currencies. Ecuador uses the U.S. dollar as its local currency. Which alternative should Laguna Co. select in order to minimize its overall exchange rate risk? Discussion in the Boardroom This exercise can be found in Appendix E at the back of this textbook. Running Your Own MNC This exercise can be found on the Xtra! website at http://maduraxtra.swlearning.com.

Chapter 12: Managing Economic Exposure and Translation Exposure

BLADES,

INC.

363

CASE

Assessment of Economic Exposure Blades, Inc., has been exporting to Thailand since its decision to supplement its declining U.S. sales by exporting there. Furthermore, Blades has recently begun exporting to a retailer in the United Kingdom. The suppliers of the components needed by Blades for roller blade production (such as rubber and plastic) are located in the United States and Thailand. Blades decided to use Thai suppliers for rubber and plastic components needed to manufacture roller blades because of cost and quality considerations. All of Blades’ exports and imports are denominated in the respective foreign currency; for example, Blades pays for the Thai imports in baht. The decision to export to Thailand was supported by the fact that Thailand had been one of the world’s fastest growing economies in recent years. Furthermore, Blades found an importer in Thailand that was willing to commit itself to the annual purchase of 180,000 pairs of Blades’ “Speedos,” which are among the highest quality roller blades in the world. The commitment began last year and will last another 2 years, at which time it may be renewed by the two parties. Due to this commitment, Blades is selling its roller blades for 4,594 baht per pair (approximately $100 at current exchange rates) instead of the usual $120 per pair. Although this price represents a substantial discount from the regular price for a pair of Speedo blades, it still constitutes a considerable markup above cost. Because importers in other Asian countries were not willing to make this type of commitment, this was a decisive factor in the choice of Thailand for exporting purposes. Although Ben Holt, Blades’ chief ﬁ nancial ofﬁcer (CFO), believes the sports product market in Asia has very high future growth potential, Blades has recently begun exporting to Jogs, Ltd., a British retailer. Jogs has committed itself to purchase 200,000 pairs of Speedos annually for a ﬁ xed price of £80 per pair. For the coming year, Blades expects to import rubber and plastic components from Thailand sufﬁcient to manufacture 80,000 pairs of Speedos, at a cost of approximately 3,000 baht per pair of Speedos. You, as Blades’ ﬁ nancial analyst, have pointed out to Ben Holt that recent events in Asia have fundamentally affected the economic condition of Asian countries, including Thailand. For example, you have pointed out that the high level of consumer spending on leisure products such as roller blades has declined considerably. Thus, the Thai retailer may not renew its

commitment with Blades in 2 years. Furthermore, you are worried that the current economic conditions in Thailand may lead to a substantial depreciation of the Thai baht, which would affect Blades negatively. Despite recent developments, however, Ben Holt remains optimistic; he is convinced that Southeast Asia will exhibit high potential for growth when the impact of recent events in Asia subsides. Consequently, Holt has no doubt that the Thai customer will renew its commitment for another 3 years when the current agreement terminates. In your opinion, Holt is not considering all of the factors that might directly or indirectly affect Blades. Moreover, you are worried that he is ignoring Blades’ future in Thailand even if the Thai importer renews its commitment for another 3 years. In fact, you believe that a renewal of the existing agreement with the Thai customer may affect Blades negatively due to the high level of inﬂation in Thailand. Since Holt is interested in your opinion and wants to assess Blades’ economic exposure in Thailand, he has asked you to conduct an analysis of the impact of the value of the baht on next year’s earnings to assess Blades’ economic exposure. You have gathered the following information: • Blades has forecasted sales in the United States

of 520,000 pairs of Speedos at regular prices; exports to Thailand of 180,000 pairs of Speedos for 4,594 baht a pair; and exports to the United Kingdom of 200,000 pairs of Speedos for £80 per pair. • Cost of goods sold for 80,000 pairs of Speedos

are incurred in Thailand; the remainder is incurred in the United States, where the cost of goods sold per pair of Speedos runs approximately $70. • Fixed costs are $2 million, and variable operating

expenses other than costs of goods sold represent approximately 11 percent of U.S. sales. All ﬁ xed and variable operating expenses other than cost of goods sold are incurred in the United States. • Recent events in Asia have increased the uncer-

tainty regarding certain Asian currencies considerably, making it extremely difﬁcult to forecast the value of the baht at which the Thai revenues will be converted. The current spot rate of the baht is $.022, and the current spot rate of the pound is $1.50. You have created three scenarios

364

Part 3: Exchange Rate Risk Management

and derived an expected value on average for the upcoming year based on each scenario:

Scenario

Effect on the Average Value of Baht

Average Value of Baht

Average Value of Pound

1

No change

$.0220

$1.530

2

Depreciate by 5%

.0209

1.485

3

Depreciate by 10%

.0198

1.500

• Blades currently has no debt in its capital struc-

ture. However, it may borrow funds in Thailand if it establishes a subsidiary in the country. Ben Holt has asked you to answer the following questions: 1. How will Blades be negatively affected by the high level of inﬂation in Thailand if the Thai customer renews its commitment for another 3 years? 2. Holt believes that the Thai importer will renew its commitment in 2 years. Do you think his assess-

SMALL

BUSINESS

ment is correct? Why or why not? Also, assume that the Thai economy returns to the high growth level that existed prior to the recent unfavorable economic events. Under this assumption, how likely is it that the Thai importer will renew its commitment in 2 years? 3. For each of the three possible values of the Thai baht and the British pound, use a spreadsheet to estimate cash ﬂows for the next year. Brieﬂy comment on the level of Blades’ economic exposure. Ignore possible tax effects. 4. Now repeat your analysis in question 3 but assume that the British pound and the Thai baht are perfectly correlated. For example, if the baht depreciates by 5 percent, the pound will also depreciate by 5 percent. Under this assumption, is Blades subject to a greater degree of economic exposure? Why or why not? 5. Based on your answers to the previous three questions, what actions could Blades take to reduce its level of economic exposure to Thailand?

DILEMMA

Hedging the Sports Exports Company’s Economic Exposure to Exchange Rate Risk Jim Logan, owner of the Sports Exports Company, remains concerned about his exposure to exchange rate risk. Even if Jim hedges his transactions from one month to another, he recognizes that a long-term trend of depreciation in the British pound could have a severe impact on his ﬁ rm. He believes that he must continue to focus on the British market for selling his footballs. However, he plans to consider various ways in which he can reduce his economic exposure. At the current time, he obtains material from a local manufacturer and uses a machine to produce the footballs, which are then ex-

I N T E R N E T/ E XC E L 1. Review an annual report of an MNC of your choice. Many MNCs provide their annual report on their websites. Look for any comments that relate to the MNC’s economic or translation exposure. Does it appear that the MNC hedges its economic

ported. He still uses his garage as a place of production and would like to continue using his garage to maintain low operating expenses. 1. How could Jim adjust his operations to reduce his economic exposure? What is a possible disadvantage of such an adjustment? 2. Offer another solution to hedging the economic exposure in the long run as Jim’s business grows. What are the disadvantages of this solution?

EXERCISES exposure or translation exposure? If so, what methods does it use to hedge its exposure? 2. Go to http://ﬁnance.yahoo.com and insert the ticker symbol IBM (or use a different MNC if you wish) in the stock quotations box. Click on 1y just

Chapter 12: Managing Economic Exposure and Translation Exposure

below the chart provided. Then scroll down and click on Historical Prices. Set the date range so that you can access data for least the last 20 quarters. Obtain the stock price of IBM at the beginning of the last 20 quarters and insert the data on your electronic spreadsheet. Compute the percentage change in the stock price of IBM from one quarter to the next. Then go to http://www.oanda.com/ convert/fxhistory and obtain direct exchange rates of the Canadian dollar and the euro that match up with the stock price data. Run a regression analysis with the quarterly percentage change in IBM’s stock price as the dependent variable and the quarterly change in the Canadian dollar’s value as the independent variable. (Appendix C explains how Excel can be used to run regression analysis.) Does it appear that IBM’s stock price is affected

365

by changes in the value of the Canadian dollar? If so, what is the direction of the relationship? Is the relationship strong? (Check the R-squared statistic.) Based on this relationship, do you think IBM should attempt to hedge its economic exposure to movements in the Canadian dollar? 3. Repeat the process using the euro in place of the Canadian dollar. Does it appear that IBM’s stock price is affected by changes in the value of the euro? If so, what is the direction of the relationship? Is the relationship strong? (Check the R-squared statistic.) Based on this relationship, do you think IBM should attempt to hedge its economic exposure to movements in the euro?

PART 3 INTEGRATIVE PROBLEM

Exchange Rate Risk Management

Vogl Co. is a U.S. ﬁ rm conducting a ﬁ nancial plan for the next year. It has no foreign subsidiaries, but more than half of its sales are from exports. Its foreign cash inﬂows to be received from exporting and cash outﬂows to be paid for imported supplies over the next year are shown in the following table: Currency

Total Inﬂow

Total Outﬂow

Canadian dollar (C$)

C$32,000,000

C$2,000,000

New Zealand dollar (NZ$)

NZ$5,000,000

NZ$1,000,000

MXP11,000,000

MXP10,000,000

Mexican peso (MXP) Singapore dollar (S$) S$4,000,000

S$8,000,000

The spot rates and one-year forward rates as of today are shown below: Currency

Spot Rate

One-Year Forward Rate

C$

$.90

$.93

NZ$

.60

.59

MXP

.18

.15

S$

.65

.64

Questions 1

Based on the information provided, determine Vogl’s net exposure to each foreign currency in dollars.

2 Assume that today’s spot rate is used as a forecast of the future spot rate one year from now. The New Zealand dollar, Mexican peso, and Singapore dollar are expected to move in tandem against the U.S. dollar over the next year. The Canadian dollar’s movements are expected to be unrelated to movements of the other currencies. Since exchange rates are difﬁcult to predict, the forecasted net dollar cash ﬂows per currency may be inaccurate. Do you anticipate any offsetting exchange rate effects from whatever exchange movements do occur? Explain. 3 Given the forecast of the Canadian dollar along with the forward rate of the Canadian dollar, what is the expected increase or decrease in dollar cash ﬂows that would result from hedging the net cash ﬂows in Canadian dollars? Would you hedge the Canadian dollar position?

366

Chapter 12: Managing Economic Exposure and Translation Exposure

367

5 Vogl Co. recognizes that its year-to-year hedging strategy hedges the risk only over a given year and does not insulate it from long-term trends in the Canadian dollar’s value. It has considered establishing a subsidiary in Canada. The goods would be sent from the United States to the Canadian subsidiary and distributed by the subsidiary. The proceeds received would be reinvested by the Canadian subsidiary in Canada. In this way, Vogl Co. would not have to convert Canadian dollars to U.S. dollars each year. Has Vogl eliminated its exposure to exchange rate risk by using this strategy? Explain.

Integrative Problem

4 Assume that the Canadian dollar net inﬂows may range from C$20 million to C$40 million over the next year. Explain the risk of hedging C$30 million in net inﬂ ows. How can Vogl Co. avoid such a risk? Is there any tradeoff resulting from your strategy to avoid that risk?

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Part 4: Long-Term Asset and Liability Management Part 4 (Chapters 13 through 18) focuses on how multinational corporations (MNCs) manage longterm assets and liabilities. Chapter 13 explains how MNCs can benefit from international business. Chapter 14 describes the information MNCs must have when considering multinational projects and demonstrates how the capital budgeting analysis is conducted. Chapter 15 identifies the common forms of multinational restructuring and illustrates how to assess the feasibility of proposed forms of restructuring. Chapter 16 explains how MNCs assess country risk associated with their prevailing projects as well as with their proposed projects. Chapter 17 explains the capital structure decision for MNCs, which affects the cost of financing new projects. Chapter 18 describes the MNC’s long-term financing decision.

Potential Revision in Host Country Tax Laws or Other Provisions

Existing Host Country Tax Laws

Exchange Rate Projections

MNC’s Access to Foreign Financing

Multinational Capital Budgeting Decisions

Country Risk Analysis

MNC’s Cost of Capital

International Interest Rates on Long-Term Funds

Estimated Cash Flows of Multinational Project

Risk Unique to Multinational Project

Required Return on Multinational Project

13: Direct Foreign Investment MNCs commonly capitalize on foreign business opportunities by engaging in direct foreign investment (DFI), which is investment in real assets (such as land, buildings, or even existing plants) in foreign countries. They engage in joint ventures with foreign ﬁrms, acquire foreign ﬁrms, and form new foreign subsidiaries. Any of these types of DFI can generate high returns when managed properly. However, DFI requires a substantial investment and can therefore put much capital at risk. Moreover, if the investment does not perform as well as expected, the MNC may have difﬁculty selling the foreign

project it created. Given these return and risk characteristics of DFI, MNCs tend to carefully analyze the potential beneﬁts and costs before implementing any type of DFI. Financial managers must understand the potential return and risk associated with DFI so that they can make investment decisions that maximize the MNC’s value. The specific objectives of this chapter are to: ■ describe common motives for initiating direct foreign

investment and ■ illustrate the benefits of international diversification.

Motives for Direct Foreign Investment MNCs commonly consider direct foreign investment because it can improve their proﬁtability and enhance shareholder wealth. In most cases, MNCs engage in DFI because they are interested in boosting revenues, reducing costs, or both.

Revenue-Related Motives The following are typical motives of MNCs that are attempting to boost revenues: • Attract new sources of demand. A corporation often reaches a stage when growth is limited in its home country, possibly because of intense competition. Even if it faces little competition, its market share in its home country may already be near its potential peak. Thus, the ﬁ rm may consider foreign markets where there is potential demand. Many developing countries, such as Argentina, Chile, Mexico, Hungary, and China, have been perceived as attractive sources of new demand. Many MNCs have penetrated these countries since barriers have been removed. Because the consumers in some countries have historically been restricted from purchasing goods produced by ﬁ rms outside their countries, the markets for some goods are not well established and offer much potential for penetration by MNCs. Blockbuster Entertainment Corp. has recently established video stores in Australia, Chile, Japan, and several European countries where the video-rental concept is relatively new. With over 2,000 stores in the United States, Blockbuster’s growth potential in the United States was limited.

E X A M P L E

370

Chapter 13: Direct Foreign Investment

371

China has also attracted MNCs. Motorola recently invested more than $1 billion in joint ventures in China. The Coca-Cola Co. has invested about $500 million in bottling facilities in China, and PepsiCo has invested about $200 million in bottling facilities. Yum Brands has KFC franchises and Pizza Hut franchises in China. Other MNCs, such as Ford Motor Co., United Technologies, General Electric, Hewlett-Packard, and IBM, have also invested more than $100 million in China to attract demand by consumers there. ■

• Enter proﬁtable markets. If other corporations in the industry have proved that superior earnings can be realized in other markets, an MNC may also decide to sell in those markets. It may plan to undercut the prevailing, excessively high prices. A common problem with this strategy is that previously established sellers in a new market may prevent a new competitor from taking away their business by lowering their prices just when the new competitor attempts to break into this market. • Exploit monopolistic advantages. Firms may become internationalized if they possess resources or skills not available to competing ﬁ rms. If a ﬁ rm possesses advanced technology and has exploited this advantage successfully in local markets, the ﬁ rm may attempt to exploit it internationally as well. In fact, the ﬁ rm may have a more distinct advantage in markets that have less advanced technology. • React to trade restrictions. In some cases, MNCs use DFI as a defensive rather than an aggressive strategy. Speciﬁcally, MNCs may pursue DFI to circumvent trade barriers. Japanese automobile manufacturers established plants in the United States in anticipation that their exports to the United States would be subject to more stringent trade restrictions. Japanese companies recognized that trade barriers could be established that would limit or prohibit their exports. By producing automobiles in the United States, Japanese manufacturers could circumvent trade barriers. ■

E X X A M P L E

• Diversify internationally. Since economies of countries do not move perfectly in tandem over time, net cash ﬂow from sales of products across countries should be more stable than comparable sales of the products in a single country. By diversifying sales (and possibly even production) internationally, a ﬁ rm can make its net cash ﬂows less volatile. Thus, the possibility of a liquidity deﬁciency is less likely. In addition, the ﬁ rm may enjoy a lower cost of capital as shareholders and creditors perceive the MNC’s risk to be lower as a result of more stable cash ﬂows. Potential beneﬁts to MNCs that diversify internationally are examined more thoroughly later in the chapter. Several firms experienced weak sales because of reduced U.S. demand for their products. They responded by increasing their expansion in foreign markets. AT&T and Nortel Networks pursued new business in China. U.S. Technology planned substantial expansion in Europe and Asia. IBM increased its presence in China, India, South Korea, and Taiwan. Cisco Systems expanded substantially in China, Japan, and South Korea. Foreign expansion diversifies an MNC’s sources of revenue and thus reduces its reliance on the U.S. economy. WalMart has not only diversified internationally but has spread its business into many emerging markets as well. Thus, it is less sensitive to a recession in the more developed countries such as those in Western Europe. ■

E X A M P L E

Cost-Related Motives MNCs also engage in DFI in an effort to reduce costs. The following are typical motives of MNCs that are trying to cut costs:

372

Part 4: Long-Term Asset and Liability Management

• Fully beneﬁt from economies of scale. A corporation that attempts to sell its primary product in new markets may increase its earnings and shareholder wealth due to economies of scale (lower average cost per unit resulting from increased production). Firms that utilize much machinery are most likely to beneﬁt from economies of scale. The removal of trade barriers by the Single European Act allowed MNCs to achieve greater economies of scale. Some U.S.-based MNCs consolidated their European plants because the removal of tariffs between countries in the European Union (EU) enabled firms to achieve economies of scale at a single European plant without incurring excessive exporting costs. The act also enhanced economies of scale by making regulations on television ads, automobile standards, and other products and services uniform across the EU. As a result, Colgate-Palmolive Co. and other MNCs are manufacturing more homogeneous products that can be sold in all EU countries. The adoption of the euro also encouraged consolidation by eliminating exchange rate risk within these countries. ■

E X A M P L E

H T T P : // http://www.cia.gov The CIA’s home page, which provides a link to the World Factbook, a valuable resource for information about countries that MNCs might be considering for direct foreign investment.

• Use foreign factors of production. Labor and land costs can vary dramatically among countries. MNCs often attempt to set up production in locations where land and labor are cheap. Due to market imperfections (as discussed in Chapter 1) such as imperfect information, relocation transaction costs, and barriers to industry entry, speciﬁc labor costs do not necessarily become equal among markets. Thus, it is worthwhile for MNCs to survey markets to determine whether they can beneﬁt from cheaper costs by producing in those markets.

E X A M P L E

Many U.S.-based MNCs, including Black & Decker, Eastman Kodak, Ford Motor Co., and General Electric, have established subsidiaries in Mexico to achieve lower labor

costs. Mexico has attracted almost $8 billion in DFI from firms in the automobile industry, primarily because of the low-cost labor. Mexican workers at General Motors’ subsidiaries who manufacture sedans and trucks earn daily wages that are less than the average hourly rate for similar workers in the United States. Ford is also producing trucks at subsidiaries based in Mexico. Non-U.S. automobile manufacturers are also capitalizing on the low-cost labor in Mexico. Volkswagen of Germany produces its Beetle in Mexico. Daimler AG of Germany manufactures its 12-wheeler trucks in Mexico, and Nissan Motor Co. of Japan produces some of its wagons in Mexico. Other Japanese companies are also increasingly using Mexico and other low-wage countries for production. For example, Sony Corp. recently established a plant in Tijuana. Matsushita Electrical Industrial Co. has a large plant in Tijuana. Baxter International has established manufacturing plants in Mexico and Malaysia to capitalize on lower costs of production (primarily wage rates). Honeywell has joint ventures in countries such as Korea and India where production costs are low. It has also established subsidiaries in countries where production costs are low, such as Mexico, Malaysia, Hong Kong, and Taiwan. ■

• Use foreign raw materials. Due to transportation costs, a corporation may attempt to avoid importing raw materials from a given country, especially when it plans to sell the ﬁ nished product back to consumers in that country. Under such circumstances, a more feasible solution may be to develop the product in the country where the raw materials are located. • Use foreign technology. Corporations are increasingly establishing overseas plants or acquiring existing overseas plants to learn the technology of foreign countries.

Chapter 13: Direct Foreign Investment

373

This technology is then used to improve their own production processes and increase production efﬁciency at all subsidiary plants around the world. • React to exchange rate movements. When a ﬁ rm perceives that a foreign currency is undervalued, the ﬁ rm may consider DFI in that country, as the initial outlay should be relatively low. A related reason for such DFI is to offset the changing demand for a company’s exports due to exchange rate ﬂuctuations. For example, when Japanese automobile manufacturers build plants in the United States, they can reduce exposure to exchange rate ﬂuctuations by incurring dollar costs for their production that offset dollar revenues. Although MNCs do not engage in large projects simply as an indirect means of speculating on currencies, the feasibility of proposed projects may be dependent on existing and expected exchange rate movements.

Cost-Related Motives in the Expanded European Union. Several countries that became part of the European Union in 2004 and 2007 were targeted for new DFI by MNCs that wanted to reduce manufacturing costs. General Motors expanded its production in Poland, Peugot increased its production in the Czech Republic, Toyota expanded its production in Slovakia, Audi expanded in Hungary, and Renault expanded in Romania. Volkswagen recently expanded its capacity in Slovenia and cut some jobs in Spain. While it originally established operations in Spain because the wages were about half of those in Germany, wages in Slovenia are less than half of those in Spain. The expansion of the EU allows new member countries to transport products throughout Europe at reduced tariffs. ■

E X X A M P L E

The shifts to low-wage countries will make manufacturers more efﬁcient and competitive, but the tradeoff is thousands of jobs lost in Western Europe. However, it may be argued that the high unionized wages encouraged the ﬁ rms to seek growth in productivity elsewhere. European labor unions tend to ﬁght layoffs but recognize that manufacturers might move completely out of the Western European countries where unions have more leverage and move into the low-wage countries in Eastern Europe. Selfish Managerial Motives for DFI In addition to the motives discussed so far, there are other selfish motives for DFI. First, managers may attempt to expand their divisions internationally if their compensation may be increased as a result of expansion. Second, many high-level managers may have large holdings of the MNC’s stock and would prefer that the MNC diversify its business internationally in order to reduce risk. This goal will not necessarily satisfy shareholders who want the MNC to focus on increasing its return. However, it will satisfy high-level managers who want to reduce risk, so that the stock price is more stable, and the value of their stock holdings is more stable. An MNC’s board of directors can attempt to oversee the proposed international projects to ensure that the DFI would serve shareholders. ■

GOVE ER RN NA AN NC CE E

H T T P : // http://www.morganstanley .com/views/gef/index.html Morgan Stanley’s Global Economic Forum, which has analyses, discussions, statistics, and forecasts related to non-U.S. economies.

Comparing Benefits of DFI among Countries Exhibit 13.1 summarizes the possible beneﬁts of DFI and explains how MNCs can use DFI to achieve those beneﬁts. Most MNCs pursue DFI based on their expectations of capitalizing on one or more of the potential beneﬁts summarized in Exhibit 13.1. The potential beneﬁts from DFI vary with the country. Countries in Western Europe have well-established markets where the demand for most products and services is large. Thus, these countries may appeal to MNCs that want to penetrate markets because they have better products than what are already being offered. Countries in

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H T T P : // http://ﬁnance.yahoo.com/ Information about economic growth and other macroeconomic indicators used when considering direct foreign investment in a foreign country.

Eastern Europe, Asia, and Latin America tend to have relatively low costs of land and labor. If an MNC desires to establish a low-cost production facility, it would also consider other factors such as the work ethic and skills of the local people, availability of labor, and cultural traits. Although most attempts to increase international business are motivated by one or more of the beneﬁts listed here, some disadvantages are also associated with DFI. Iowa Co., a large clothing manufacturer, wants to pursue DFI in the Philippines or Mexico because the cost of producing its clothing will be much lower in either country. Iowa Co. determines that the direct costs of production would be lower in the Philippines. However, there are some other indirect costs of DFI that should also be considered. Iowa Co. determines that economic conditions in the Philippines are uncertain, that government restrictions might be imposed on a subsidiary there, and that inﬂation and exchange rate movements might be unfavorable. Most importantly, the safety of employees who would be sent there to manage the subsidiary might be threatened by terrorist groups. After considering all the costs, Iowa Co. decides not to pursue DFI in the Philippines. ■

E X A M M P L L E

H T T P : // http://www.worldbank.org Valuable updated country data that can be considered when making DFI decisions.

Comparing Benefits of DFI over Time As conditions change over time, so do possible beneﬁts from pursuing direct foreign investment in various countries. Thus, some countries may become more attractive targets while other countries become less attractive. The choice of target countries for DFI has changed over time. Canada now receives a smaller proportion of total

Exhibit 13.1

Summary of Motives for Direct Foreign Investment Means of Using DFI to Achieve This Beneﬁt

Revenue-Related Motives 1. Attract new sources of demand.

Establish a subsidiary or acquire a competitor in a new market.

2. Enter markets where superior proﬁts are possible.

Acquire a competitor that has controlled its local market.

3. Exploit monopolistic advantages.

Establish a subsidiary in a market where competitors are unable to produce the identical product; sell products in that country.

4. React to trade restrictions.

Establish a subsidiary in a market where tougher trade restrictions will adversely affect the ﬁrm’s export volume.

5. Diversify internationally.

Establish subsidiaries in markets whose business cycles differ from those where existing subsidiaries are based.

Cost-Related Motives 6. Fully beneﬁt from economies of scale.

Establish a subsidiary in a new market that can sell products produced elsewhere; this allows for increased production and possibly greater production efﬁciency.

7. Use foreign factors of production.

Establish a subsidiary in a market that has relatively low costs of labor or land; sell the ﬁnished product to countries where the cost of production is higher.

8. Use foreign raw materials.

Establish a subsidiary in a market where raw materials are cheap and accessible; sell the ﬁnished product to countries where the raw materials are more expensive.

9. Use foreign technology.

Participate in a joint venture in order to learn about a production process or other operations.

10. React to exchange rate movements.

Establish a subsidiary in a new market where the local currency is weak but is expected to strengthen over time.

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DFI than it received in the past, while Europe, Latin America, and Asia receive a larger proportion than in the past. More than one-half of all DFI by U.S. ﬁ rms is in European countries. The opening of the Eastern European countries and the expansion of the EU account for some of the increased DFI in Europe, especially Eastern Europe. The increased focus on Latin America is partially attributed to its high economic growth, which has encouraged MNCs to capitalize on new sources of demand for their products. In addition, MNCs have targeted Latin America and Asia to use factors of production that are less expensive in foreign countries than in the United States. Last year Georgia Co. contemplated DFI in Thailand, where it would produce and sell cell phones. It decided that costs were too high. Now it is reconsidering because costs in Thailand have declined. Georgia could lease office space at a low cost. It could also purchase a manufacturing plant at a lower cost because factories that recently failed are standing empty. In addition, the Thai baht has depreciated substantially against the dollar recently, so Georgia Co. could invest in Thailand at a time when the dollar can be exchanged at a favorable exchange rate. Georgia Co. also dicovers, however, that while the cost-related characteristics have improved, the revenue-related characteristics are now less desirable. A new subsidiary in Thailand might not attract new sources of demand due to the country’s weak economy. In addition, Georgia might be unable to earn excessive profits there because the weak economy might force existing firms to keep their prices very low in order to survive. Georgia Co. must compare the favorable aspects of DFI in Thailand with the unfavorable aspects by using multinational capital budgeting, which is explained in the following chapter. ■

E X A M P L E

Benefits of International Diversification An international project can reduce a ﬁ rm’s overall risk as a result of international diversiﬁcation beneﬁts. The key to international diversiﬁcation is selecting foreign projects whose performance levels are not highly correlated over time. In this way, the various international projects should not experience poor performance simultaneously. Merrimack Co., a U.S. firm, plans to invest in a new project in either the United States or the United Kingdom. Once the project is completed, it will constitute 30 percent of the firm’s total funds invested in itself. The remaining 70 percent of its investment in its business is exclusively in the United States. Characteristics of the proposed project are forecasted for a 5-year period for both a U.S. and a British location, as shown in Exhibit 13.2. Merrimack Co. plans to assess the feasibility of each proposed project based on expected risk and return, using a 5-year time horizon. Its expected annual after-tax return on investment on its prevailing business is 20 percent, and its variability of returns (as measured

E X X A M P L E

Exhibit 13.2

Evaluation of Proposed Projects in Alternative Locations Characteristics of Proposed Project Existing Business

If Located in the United States

If Located in the United Kingdom

20%

25%

25%

Standard deviation of expected annual after-tax returns on investment

.10

.09

.11

Correlation of expected annual after-tax returns on investment with after-tax returns of prevailing U.S. business

—

.80

.02

Mean expected annual return on investment (after taxes)

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H T T P : // http://www.trade.gov/mas/ Outlook of international trade conditions for each of several industries.

by the standard deviation) is expected to be .10. The firm can assess its expected overall performance based on developing the project in the United States and in the United Kingdom. In doing so, it is essentially comparing two portfolios. In the first portfolio, 70 percent of its total funds are invested in its prevailing U.S. business, with the remaining 30 percent invested in a new project located in the United States. In the second portfolio, again 70 percent of the firm’s total funds are invested in its prevailing business, but the remaining 30 percent are invested in a new project located in the United Kingdom. Therefore, 70 percent of the portfolios’ investments are identical. The difference is in the remaining 30 percent of funds invested. If the new project is located in the United States, the firm’s overall expected after-tax return (rp) is rp

[(70%)

% of funds invested in prevailing business

(20%)] Expected return on prevailing business

[(30%)

% of funds invested in new U.S. project

(25%)]

Expected return on new U.S. project

21.5% Firm’s overall expected return

This computation is based on weighting the returns according to the percentage of total funds invested in each investment. If the firm calculates its overall expected return with the new project located in the United Kingdom instead of the United States, the results are unchanged. This is because the new project’s expected return is the same regardless of the country of location. Therefore, in terms of return, neither new project has an advantage. With regard to risk, the new project is expected to exhibit slightly less variability in returns during the 5-year period if it is located in the United States (see Exhibit 13.2). Since firms typically prefer more stable returns on their investments, this is an advantage. However, estimating the risk of the individual project without considering the overall firm would be a mistake. The expected correlation of the new project’s returns with those of the prevailing business must also be considered. Recall that portfolio variance is determined by the individual variability of each component as well as their pairwise correlations. The variance of a portfolio (s2p ) composed of only two investments (A and B) is computed as

s2p 5 w 2AsA2 1 w 2B sB2 1 2wA wB sA sB (CORR AB ) where wA and wB represent the percentage of total funds allocated to investments A and B, respectively; sA and sB are the standard deviations of returns on investments A and B, respectively, and CORR AB is the correlation coefficient of returns between investments A and B. This equation for portfolio variance can be applied to the problem at hand. The portfolio reﬂects the overall firm. First, compute the overall firm’s variance in returns assuming it locates the new project in the United States (based on the information provided in Exhibit 13.2). This variance (s2p ) is

s2p 5 (.70)2(.10)2 1 (.30)2(.09)2 1 2(.70)(.30)(.10)(.09)(.80) 5 (.49)(.01) 1 (.09)(.0081) 1 .003024 5 .0049 1 .000729 1 .003024 5 .008653 If Merrimack Co. decides to locate the new project in the United Kingdom instead of the United States, its overall variability in returns will be different because that project differs from the new U.S. project in terms of individual variability in returns and correlation with the prevailing business. The overall variability of the firm’s returns based on locating the new project in the United Kingdom is estimated by variance in the portfolio returns (s2p ):

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s 2p 5 (.70)2(.10)2 1 (.30)2(.11)2 1 2(.70)(.30)(.10)(.11)(.02) 5 (.49)(.01) 1 (.09)(.0121) 1 .0000924 5 .0049 1 .001089 1 .0000924 5 .0060814 Thus, Merrimack will generate more stable returns if the new project is located in the United Kingdom. The firm’s overall variability in returns is almost 29.7 percent less if the new project is located in the United Kingdom rather than in the United States. The variability is reduced when locating in the foreign country because of the correlation of the new project’s expected returns with the expected returns of the prevailing business. If the new project is located in Merrimack’s home country (the United States), its returns are expected to be more highly correlated with those of the prevailing business than they would be if the project was located in the United Kingdom. When economic conditions of two countries (such as the United States and the United Kingdom) are not highly correlated, then a firm may reduce its risk by diversifying its business in both countries instead of concentrating in just one. ■

Diversification Analysis of International Projects Like any investor, an MNC with investments positioned around the world is concerned with the risk and return characteristics of the investments. The portfolio of all investments reﬂects the MNC in aggregate. Virginia, Inc., considers a global strategy of developing projects as shown in Exhibit 13.3. Each point on the graph reﬂects a specific project that either has been implemented or is being considered. The return axis may be measured by potential return on assets or return on equity. The risk may be measured by potential ﬂuctuation in the returns generated by each project. Exhibit 13.3 shows that Project A has the highest expected return of all the projects. While Virginia, Inc., could devote most of its resources toward this project to attempt to achieve such a high return, its risk is possibly too high by itself. In addition, such a project may not be able to absorb all available capital anyway if its potential market for customers is limited. Thus, Virginia, Inc., develops a portfolio of projects. By combining Project A with several other projects, Virginia, Inc., may decrease its expected return. On the other hand, it may also reduce its risk substantially.

E X X A M P L E

Expected Return

Exhibit 13.3

Risk-Return Analysis of International Projects

A

Frontier of Efﬁcient Project Portfolios B C

D E

G

F

Risk

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H T T P : // http://www.treasury.gov Links to international information that should be considered by MNCs that are considering direct foreign investment.

If Virginia, Inc., appropriately combines projects, its project portfolio may be able to achieve a risk-return tradeoff exhibited by any of the points on the curve in Exhibit 13.3. This curve represents a frontier of efficient project portfolios that exhibit desirable risk-return characteristics, in that no single project could outperform any of these portfolios. The term efficient refers to a minimum risk for a given expected return. Project portfolios outperform the individual projects considered by Virginia, Inc., because of the diversification attributes discussed earlier. The lower, or more negative, the correlation in project returns over time, the lower will be the project portfolio risk. As new projects are proposed, the frontier of efficient project portfolios available to Virginia, Inc., may shift. ■

Comparing Portfolios along the Frontier. Along the frontier of efﬁcient project portfolios, no portfolio can be singled out as “optimal” for all MNCs. This is because MNCs vary in their willingness to accept risk. If the MNC is very conservative and has the choice of any portfolios represented by the frontier in Exhibit 13.3, it will probably prefer one that exhibits low risk (near the bottom of the frontier). Conversely, a more aggressive strategy would be to implement a portfolio of projects that exhibits risk-return characteristics such as those near the top of the frontier. Comparing Frontiers among MNCs. The actual location of the frontier of efﬁcient project portfolios depends on the business in which the firm is involved. Some MNCs have frontiers of possible project portfolios that are more desirable than the frontiers of other MNCs. Eurosteel, Inc., sells steel solely to European nations and is considering other related projects. Its frontier of efficient project portfolios exhibits considerable risk (because it sells just one product to countries whose economies move in tandem). In contrast, Global Products, Inc., which sells a wide range of products to countries all over the world, has a lower degree of project portfolio risk. Therefore, its frontier of efficient project portfolios is closer to the vertical axis. This comparison is illustrated in Exhibit 13.4. Of course, this comparison assumes that Global Products, Inc., is knowledgeable about all of its products and the markets where it sells. ■

E X A M P L E

Our discussion suggests that MNCs can achieve more desirable risk-return characteristics from their project portfolios if they sufﬁciently diversify among products and

Expected Return

Exhibit 13.4

Risk-Return Advantage of a Diversiﬁed MNC

Efﬁcient Frontier of Project Portfolios for Multiproduct MNC

Efﬁcient Frontier of Project Portfolios for MNC That Sells Steel to European Nations

Risk

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geographic markets. This also relates to the advantage an MNC has over a purely domestic ﬁ rm with only a local market. The MNC may be able to develop a more efﬁcient portfolio of projects than its domestic counterpart.

Diversification among Countries Exhibit 13.5 shows how the stock market values of various countries have changed over time. A country’s stock market value reﬂects the expectations of business opportunities and economic growth. Notice how the changes in stock market values vary among countries, which suggests that business and economic conditions vary among countries. Thus, when an MNC diversiﬁes its business among countries rather than focusing on only one foreign country, it reduces its exposure to any single foreign country. However, economic conditions are commonly correlated over time, because the weakness of one country may cause a reduction in imports demanded from other countries. Notice that in 2002 (when the United States experienced a recession), all stock markets in Exhibit 13.5 were weak, reﬂecting expectations of weak economic conditions in these countries. Yet, the degree of weakness varies over time. Economic conditions were strong in the 2005–2006 period, but were especially strong in emerging markets such as Brazil, India, and Mexico.

Exhibit 13.5

Comparison of Expected Economic Growth among Countries: Annual Stock Market Return

Brazil

India

100

100

50

50

0

0

–50

2000 2001 2002 2003 2004 2005 2006

–50

Italy

Mexico

100

100

50

50

0

0

–50

2000 2001 2002 2003 2004 2005 2006

–50

United Kingdom 100

50

50

0

0

2000 2001 2002 2003 2004 2005 2006

2000 2001 2002 2003 2004 2005 2006 United States

100

–50

2000 2001 2002 2003 2004 2005 2006

–50

2000 2001 2002 2003 2004 2005 2006

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Decisions Subsequent to DFI Once direct foreign investment takes place, periodic decisions are necessary to determine whether further expansion should take place in a given location. In addition, as the project generates earnings, the MNC must decide whether to have the funds remitted to the parent or used by the subsidiary. If the subsidiary has a use for the funds that would be of more value than the parent’s use, the subsidiary should retain the funds. Of course, a certain percentage of the funds will be needed to maintain operations, but the remaining funds can be sent to the parent, sent to another subsidiary, or reinvested for expansion purposes. Facts relevant to the decision of whether the subsidiary should reinvest the earnings should be analyzed on a case-by-case basis. The appropriate decision depends on the economic conditions in the subsidiary’s country and the parent’s country, as well as restrictions imposed by the host country government.

Host Government Views of DFI Each government must weigh the advantages and disadvantages of direct foreign investment in its country. It may provide incentives to encourage some forms of DFI, barriers to prevent other forms of DFI, and impose conditions on some other forms of DFI.

Incentives to Encourage DFI The ideal DFI solves problems such as unemployment and lack of technology without taking business away from local ﬁ rms. Consider an MNC that is willing to build a production plant in a foreign country that will use local labor and produce goods that are not direct substitutes for other locally produced goods. In this case, the plant will not cause a reduction in sales by local firms. The host government would normally be receptive toward this type of DFI. Another desirable form of DFI from the perspective of the host government is a manufacturing plant that uses local labor and then exports the products (assuming no other local firm exports such products to the same areas). ■

E X A M P L E

H T T P : // http://www.pwcglobal.com Access to country-speciﬁc information such as general business rules and regulations, tax environments, and some other useful statistics and surveys.

In some cases, a government will offer incentives to MNCs that consider DFI in its country. Governments are particularly willing to offer incentives for DFI that will result in the employment of local citizens or an increase in technology. Common incentives offered by the host government include tax breaks on the income earned there, rent-free land and buildings, low-interest loans, subsidized energy, and reduced environmental regulations. The degree to which a government will offer such incentives depends on the extent to which the MNC’s DFI will beneﬁt that country. The decision by Allied Research Associates, Inc. (a U.S.-based MNC), to build a production facility and office in Belgium was highly motivated by Belgian government subsidies. The Belgian government subsidized a large portion of the expenses incurred by Allied Research Associates and offered tax concessions and favorable interest rates on loans to Allied. ■

E X A M P L E

While many governments encourage DFI, they use different types of incentives. France has periodically sold government land at a discount, while Finland and Ireland attracted MNCs in the late 1990s by imposing a very low corporate tax rate on speciﬁc businesses.

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Barriers to DFI Governments are less anxious to encourage DFI that adversely affects locally owned companies, unless they believe that the increased competition is needed to serve consumers. Therefore, they tend to closely regulate any DFI that may affect local ﬁ rms, consumers, and economic conditions.

Protective Barriers. When MNCs consider engaging in DFI by acquiring a foreign company, they may face various barriers imposed by host government agencies. All countries have one or more government agencies that monitor mergers and acquisitions. These agencies may prevent an MNC from acquiring companies in their country if they believe it will attempt to lay off employees. They may even restrict foreign ownership of any local ﬁ rms.

“Red Tape” Barriers. An implicit barrier to DFI in some countries is the “red tape” involved, such as procedural and documentation requirements. An MNC pursuing DFI is subject to a different set of requirements in each country. Therefore, it is difﬁcult for an MNC to become proﬁcient at the process unless it concentrates on DFI within a single foreign country. The current efforts to make regulations uniform across Europe have simpliﬁed the paperwork required to acquire European ﬁ rms.

Industry Barriers. The local ﬁ rms of some industries in particular countries have substantial inﬂuence on the government and will likely use their inﬂuence to prevent competition from MNCs that attempt DFI. MNCs that consider DFI need to recognize the inﬂuence that these local ﬁ rms have on the local government. Environmental Barriers. Each country enforces its own environmental constraints. Some countries may enforce more of these restrictions on a subsidiary whose parent is based in a different country. Building codes, disposal of production waste materials, and pollution controls are examples of restrictions that force subsidiaries to incur additional costs. Many European countries have recently imposed tougher antipollution laws as a result of severe problems.

Regulatory Barriers. Each country also enforces its own regulatory constraints pertaining to taxes, currency convertibility, earnings remittance, employee rights, and other policies that can affect cash ﬂows of a subsidiary established there. Because these regulations can inﬂuence cash ﬂows, ﬁ nancial managers must consider them when assessing policies. Also, any change in these regulations may require revision of existing ﬁ nancial policies, so ﬁ nancial managers should monitor the regulations for any potential changes over time. Some countries may require extensive protection of employee rights. If so, managers should attempt to reward employees for efﬁcient production so that the goals of labor and shareholders will be closely aligned. Ethical Differences. There is no consensus standard of business conduct that applies to all countries. A business practice that is perceived to be unethical in one country may be totally ethical in another. For example, U.S.-based MNCs are well aware that certain business practices that are accepted in some less developed countries would be illegal in the United States. Bribes to governments in order to receive special tax breaks or other favors are common in some countries. If MNCs do not participate in such practices, they may be at a competitive disadvantage when attempting DFI in a particular country.

Political Instability. The governments of some countries may prevent DFI. If a country is susceptible to abrupt changes in government and political conﬂicts, the feasibility of DFI may be dependent on the outcome of those conﬂicts. MNCs want

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to avoid a situation in which they pursue DFI under a government that is likely to be removed after the DFI occurs.

H T T P : // http://www.transparency .org/ The Political Instability section has information about corruption in some countries.

Government-Imposed Conditions to Engage in DFI Some governments allow international acquisitions but impose special requirements on MNCs that desire to acquire a local ﬁ rm. For example, the MNC may be required to ensure pollution control for its manufacturing or to structure the business to export the products it produces so that it does not threaten the market share of other local ﬁ rms. The MNC may even be required to retain all the employees of the target ﬁ rm so that unemployment and general economic conditions in the country are not adversely affected. Mexico requires that a specified minimum proportion of parts used to produce automobiles there are made in Mexico. The proportion is lower for automobiles that are to be exported. Spain’s government allowed Ford Motor Co. to set up production facilities in Spain only if it would abide by certain provisions. These included limiting Ford’s local sales volume to 10 percent of the previous year’s local automobile sales. In addition, two-thirds of the total volume of automobiles produced by Ford in Spain must be exported. The idea behind these provisions was to create jobs for workers in Spain without seriously affecting local competitors. Allowing a subsidiary that primarily exports its product achieved this objective. ■

E X A M P L E

Government-imposed conditions do not necessarily prevent an MNC from pursuing DFI in a speciﬁc foreign country, but they can be costly. Thus, MNCs should be willing to consider DFI that requires costly conditions only if the potential beneﬁts outweigh the costs.

SUMMARY ■ MNCs may be motivated to initiate direct foreign investment in order to attract new sources of demand or to enter markets where superior proﬁts are possible. These two motives are normally based on opportunities to generate more revenue in foreign markets. Other motives for using DFI are typically related to cost efﬁciency, such as using foreign factors of production, raw materials, or technology. In addition MNCs may engage in DFI to protect their foreign market share, to react to exchange rate movements, or to avoid trade restrictions.

reduce its exposure to domestic economic conditions. In this way, the MNC may be able to stabilize its cash ﬂows and reduce its risk. Such a goal is desirable because it may reduce the ﬁ rm’s cost of ﬁnancing. International projects may allow MNCs to achieve lower risk than is possible from only domestic projects without reducing their expected returns. International diversiﬁcation tends to be better able to reduce risk when the DFI is targeted to countries whose economies are somewhat unrelated to an MNC’s home country economy.

■ International diversiﬁcation is a common motive for direct foreign investment. It allows an MNC to

POINT

COUNTER-POINT

Should MNCs Avoid DFI in Countries with Liberal Child Labor Laws? Point Yes. An MNC should maintain its hiring standards, regardless of what country it is in. Even if a foreign country allows children to work, an MNC

should not lower its standards. Although the MNC forgoes the use of low-cost labor, it maintains its global credibility.

Chapter 13: Direct Foreign Investment

Counter-Point No. An MNC will not only beneﬁt its shareholders, but will create employment for some children who need support. The MNC can provide reasonable working conditions and perhaps may even offer educational programs for its employees.

SELF

383

Who Is Correct? Use the Internet to learn more about this issue. Which argument do you support? Offer your own opinion on this issue.

TEST 4. Why do you think U.S. ﬁ rms commonly use joint ventures as a strategy to enter China?

Answers are provided in Appendix A at the back of the text. 1. Offer some reasons why U.S. ﬁ rms might prefer to engage in direct foreign investment (DFI) in Canada rather than Mexico. 2. Offer some reasons why U.S. ﬁ rms might prefer to direct their DFI to Mexico rather than Canada.

5. Why would the United States offer a foreign automobile manufacturer large incentives for establishing a production subsidiary in the United States? Isn’t this strategy indirectly subsidizing the foreign competitors of U.S. ﬁ rms?

3. One U.S. executive said that Europe was not considered as a location for DFI because of the euro’s value. Interpret this statement.

QUESTIONS

AND

A P P L I CAT I O N S

1. Motives for DFI. Describe some potential beneﬁts to an MNC as a result of direct foreign investment (DFI). Elaborate on each type of beneﬁt. Which motives for DFI do you think encouraged Nike to expand its footwear production in Latin America? 2. Impact of a Weak Currency on Feasibility of DFI. Packer, Inc., a U.S. producer of computer disks, plans to establish a subsidiary in Mexico in order to penetrate the Mexican market. Packer’s executives believe that the Mexican peso’s value is relatively strong and will weaken against the dollar over time. If their expectations about the peso’s value are correct, how will this affect the feasibility of the project? Explain. 3. DFI to Achieve Economies of Scale. Bear Co. and Viking, Inc., are automobile manufacturers that desire to beneﬁt from economies of scale. Bear Co. has decided to establish distributorship subsidiaries in various countries, while Viking, Inc., has decided to establish manufacturing subsidiaries in various countries. Which ﬁ rm is more likely to beneﬁt from economies of scale? 4. DFI to Reduce Cash Flow Volatility. Raider Chemical Co. and Ram, Inc., had similar intentions to reduce the volatility of their cash ﬂows. Raider implemented a long-range plan to establish 40 percent of

its business in Canada. Ram, Inc., implemented a long-range plan to establish 30 percent of its business in Europe and Asia, scattered among 12 different countries. Which company will more effectively reduce cash ﬂow volatility once the plans are achieved? 5. Impact of Import Restrictions. If the United States imposed long-term restrictions on imports, would the amount of DFI by non-U.S. MNCs in the United States increase, decrease, or be unchanged? Explain. 6. Capitalizing on Low-Cost Labor. Some MNCs establish a manufacturing facility where there is a relatively low cost of labor. Yet, they sometimes close the facility later because the cost advantage dissipates. Why do you think the relative cost advantage of these countries is reduced over time? (Ignore possible exchange rate effects.) 7. Opportunities in Less Developed Countries. Offer your opinion on why economies of some less developed countries with strict restrictions on international trade and DFI are somewhat independent from economies of other countries. Why would MNCs desire to enter such countries? If these countries relaxed their restrictions, would their economies continue to be independent of other economies? Explain.

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8. Effects of September 11. In August 2001, Ohio, Inc., considered establishing a manufacturing plant in central Asia, which would be used to cover its exports to Japan and Hong Kong. The cost of labor was very low in central Asia. On September 11, 2001, the terrorist attacks on the United States caused Ohio to reassess the potential cost savings. Why would the estimated expenses of the plant increase after the terrorist attacks? 9. DFI Strategy. Bronco Corp. has decided to establish a subsidiary in Taiwan that will produce stereos and sell them there. It expects that its cost of producing these stereos will be one-third the cost of producing them in the United States. Assuming that its production cost estimates are accurate, is Bronco’s strategy sensible? Explain. 10. Risk Resulting from International Business. This chapter concentrates on possible beneﬁts to a ﬁ rm that increases its international business. a. What are some risks of international business

that may not exist for local business? b. What does this chapter reveal about the relation-

ship between an MNC’s degree of international business and its risk? 11. Motives for DFI. Starter Corp. of New Haven, Connecticut, produces sportswear that is licensed by professional sports teams. It recently decided to expand in Europe. What are the potential beneﬁts for this ﬁ rm from using DFI? 12. Disney’s DFI Motives. What potential beneﬁts do you think were most important in the decision of the Walt Disney Co. to build a theme park in France? 13. DFI Strategy. Once an MNC establishes a subsidiary, DFI remains an ongoing decision. What does this statement mean?

local partners who knew the preferences of the local customers. a. What comparative advantage does J.C. Penney have when establishing a store in a foreign country, relative to an independent variety store? b. Why might the overall risk of J.C. Penney decrease or increase as a result of its recent global expansion? c. J.C. Penney has been more cautious about entering China. Explain the potential obstacles associated with entering China.

16. DFI Location Decision. Decko Co. is a U.S. ﬁ rm with a Chinese subsidiary that produces cell phones in China and sells them in Japan. This subsidiary pays its wages and its rent in Chinese yuan, which is stable relative to the dollar. The cell phones sold to Japan are denominated in Japanese yen. Assume that Decko Co. expects that the Chinese yuan will continue to stay stable against the dollar. The subsidiary’s main goal is to generate proﬁts for itself and reinvest the proﬁts. It does not plan to remit any funds to the U.S. parent. a. Assume that the Japanese yen strengthens against the U.S. dollar over time. How would this be expected to affect the proﬁts earned by the Chinese subsidiary? b. If Decko Co. had established its subsidiary in Tokyo, Japan, instead of China, would its subsidiary’s proﬁts be more exposed or less exposed to exchange rate risk? c. Why do you think that Decko Co. established the subsidiary in China instead of Japan? Assume no major country risk barriers. d. If the Chinese subsidiary needs to borrow money to ﬁ nance its expansion and wants to reduce its exchange rate risk, should it borrow U.S. dollars, Chinese yuan, or Japanese yen?

14. Host Government Incentives for DFI. Why would foreign governments provide MNCs with incentives to undertake DFI there?

Discussion in the Boardroom

Advanced Questions

This exercise can be found in Appendix E at the back of this textbook.

15. DFI Strategy. J.C. Penney has recognized numerous opportunities to expand in foreign countries and has assessed many foreign markets, including Brazil, Greece, Mexico, Portugal, Singapore, and Thailand. It has opened new stores in Europe, Asia, and Latin America. In each case, the ﬁ rm was aware that it did not have sufﬁcient understanding of the culture of each country that it had targeted. Consequently, it engaged in joint ventures with

Running Your Own MNC This exercise can be found on the Xtra! website at http://maduraxtra.swlearning.com.

Chapter 13: Direct Foreign Investment

BLADES,

INC.

385

CASE

Consideration of Direct Foreign Investment For the last year, Blades, Inc., has been exporting to Thailand in order to supplement its declining U.S. sales. Under the existing arrangement, Blades sells 180,000 pairs of roller blades annually to Entertainment Products, a Thai retailer, for a ﬁ xed price denominated in Thai baht. The agreement will last for another 2 years. Furthermore, to diversify internationally and to take advantage of an attractive offer by Jogs, Ltd., a British retailer, Blades has recently begun exporting to the United Kingdom. Under the resulting agreement, Jogs will purchase 200,000 pairs of “Speedos,” Blades’ primary product, annually at a ﬁ xed price of £80 per pair. Blades’ suppliers of the needed components for its roller blade production are located primarily in the United States, where Blades incurs the majority of its cost of goods sold. Although prices for inputs needed to manufacture roller blades vary, recent costs have run approximately $70 per pair. Blades also imports components from Thailand because of the relatively low price of rubber and plastic components and because of their high quality. These imports are denominated in Thai baht, and the exact price (in baht) depends on prevailing market prices for these components in Thailand. Currently, inputs sufﬁcient to manufacture a pair of roller blades cost approximately 3,000 Thai baht per pair of roller blades. Although Thailand had been among the world’s fastest growing economies, recent events in Thailand have increased the level of economic uncertainty. Speciﬁcally, the Thai baht, which had been pegged to the dollar, is now a freely ﬂoating currency and has depreciated substantially in recent months. Furthermore, recent levels of inﬂation in Thailand have been very high. Hence, future economic conditions in Thailand are highly uncertain. Ben Holt, Blades’ chief ﬁ nancial ofﬁcer (CFO), is seriously considering DFI in Thailand. He believes that this is a perfect time to either establish a subsidiary or acquire an existing business in Thailand because the uncertain economic conditions and the depreciation of the baht have substantially lowered the initial costs required for DFI. Holt believes the growth potential in Asia will be extremely high once the Thai economy stabilizes. Although Holt has also considered DFI in the United Kingdom, he would prefer that Blades invest in Thailand as opposed to the United Kingdom. Forecasts indicate that the demand for roller blades in the United Kingdom is similar to that in the United States; since

Blades’ U.S. sales have recently declined because of the high prices it charges, Holt expects that DFI in the United Kingdom will yield similar results, especially since the components required to manufacture roller blades are more expensive in the United Kingdom than in the United States. Furthermore, both domestic and foreign roller blade manufacturers are relatively well established in the United Kingdom, so the growth potential there is limited. Holt believes the Thai roller blade market offers more growth potential. Blades can sell its products at a lower price but generate higher proﬁt margins in Thailand than it can in the United States. This is because the Thai customer has committed itself to purchase a ﬁ xed number of Blades’ products annually only if it can purchase Speedos at a substantial discount from the U.S. price. Nevertheless, since the cost of goods sold incurred in Thailand is substantially below that incurred in the United States, Blades has managed to generate higher proﬁt margins from its Thai exports and imports than in the United States. As a ﬁ nancial analyst for Blades, Inc., you generally agree with Ben Holt’s assessment of the situation. However, you are concerned that Thai consumers have not been affected yet by the unfavorable economic conditions. You believe that they may reduce their spending on leisure products within the next year. Therefore, you think it would be beneﬁcial to wait until next year, when the unfavorable economic conditions in Thailand may subside, to make a decision regarding DFI in Thailand. However, if economic conditions in Thailand improve over the next year, DFI may become more expensive both because target ﬁ rms will be more expensive and because the baht may appreciate. You are also aware that several of Blades’ U.S. competitors are considering expanding into Thailand in the next year. If Blades acquires an existing business in Thailand or establishes a subsidiary there by the end of next year, it would fulﬁ ll its agreement with Entertainment Products for the subsequent year. The Thai retailer has expressed an interest in renewing the contractual agreement with Blades at that time if Blades establishes operations in Thailand. However, Holt believes that Blades could charge a higher price for its products if it establishes its own distribution channels. Holt has asked you to answer the following questions: 1. Identify and discuss some of the beneﬁts that Blades, Inc., could obtain from DFI.

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2. Do you think Blades should wait until next year to undertake DFI in Thailand? What is the tradeoff if Blades undertakes the DFI now? 3. Do you think Blades should renew its agreement with the Thai retailer for another 3 years? What is the tradeoff if Blades renews the agreement?

Blades, Inc. How do you think the Thai government would view the establishment of a subsidiary in Thailand by ﬁ rms such as Blades? Do you think the Thai government would be more or less supportive if ﬁ rms such as Blades acquired existing businesses in Thailand? Why?

4. Assume a high level of unemployment in Thailand and a unique production process employed by

SMALL

BUSINESS

DILEMMA

Direct Foreign Investment Decision by the Sports Exports Company Jim Logan’s business, the Sports Exports Company, continues to grow. His primary product is the footballs he produces and exports to a distributor in the United Kingdom. However, his recent joint venture with a British ﬁ rm has also been successful. Under this arrangement, a British ﬁ rm produces other sporting goods for Jim’s ﬁ rm; these goods are then delivered to that distributor. Jim intentionally started his international business by exporting because it was easier and cheaper to export than to establish a place of business in the United Kingdom. However, he is considering establishing a ﬁ rm in the United Kingdom to produce the footballs there instead of in his garage (in the

I N T E R N E T/ E XC E L IBM has substantial operations in many countries, including the United States, Canada, and Germany. Go to http://ﬁnance.yahoo.com/q?s=ibm and click on 1y just below the chart provided. 1. Scroll down and click on Historical Prices. (Or apply this exercise to a different MNC.) Set the date range so that you can obtain quarterly values of the U.S. stock index for the last 20 quarters. Insert the quarterly data on a spreadsheet. Compute the percentage change in IBM’s stock price for each quarter. Then go to http://ﬁnance.yahoo.com/ intlindices?e=americas and click on index GSPC (which represents the U.S. stock market index), so that you can derive the quarterly percentage change in the U.S. stock index over the last 20 quarters. Then run a regression analysis with IBM’s quarterly return (percentage change in stock price) as the dependent variable and the quarterly percentage

United States). This ﬁ rm would also produce the other sporting goods that he now sells, so he would no longer have to rely on another British ﬁ rm (through the joint venture) to produce those goods. 1. Given the information provided here, what are the advantages to Jim of establishing the ﬁ rm in the United Kingdom? 2. Given the information provided here, what are the disadvantages to Jim of establishing the ﬁ rm in the United Kingdom?

EXERCISES change in the U.S. stock market’s value as the independent variable. (Appendix C explains how Excel can be used to run regression analysis.) The slope coefﬁcient serves as an estimate of the sensitivity of IBM’s value to the U.S. market returns. Also, check the ﬁt of the relationship based on the R-squared statistic. 2. Go to http://ﬁnance.yahoo.com/intlindices? e=europe and click on GDAXI (the German stock market index). Repeat the process so that you can assess IBM’s sensitivity to the German stock market. Compare the slope coefﬁcient between the two analyses. Is IBM’s value more sensitive to the U.S. market or the German market? Does the U.S. market or the German market explain a higher proportion of the variation in IBM’s returns (check the R-squared statistic)? Offer an explanation of your results.

14: Multinational Capital Budgeting Multinational corporations (MNCs) evaluate international projects by using multinational capital budgeting, which compares the beneﬁts and costs of these projects. Given that many MNCs spend more than $100 million per year on international projects, multinational capital budgeting is a critical function. Many international projects are irreversible and cannot be easily sold to other corporations at a reasonable price. Proper use of multinational capital budgeting can identify the international projects worthy of implementation. The most popular method of capital budgeting involves determining the project’s net present value by estimating the present value of the project’s future cash ﬂows and subtracting the initial outlay required for the project. Multinational capital budgeting typically uses a similar process. However, special circumstances of inter-

national projects that affect the future cash ﬂows or the discount rate used to discount cash ﬂows make multinational capital budgeting more complex. Financial managers must understand how to apply capital budgeting to international projects, so that they can maximize the value of the MNC. The specific objectives of this chapter are to: ■ compare the capital budgeting analysis of an MNC’s

subsidiary versus its parent, ■ demonstrate how multinational capital budgeting can

be applied to determine whether an international project should be implemented, and ■ explain how the risk of international projects can be

assessed.

Subsidiary versus Parent Perspective Should capital budgeting for a multinational project be conducted from the viewpoint of the subsidiary that will administer the project or the parent that will most likely ﬁ nance much of the project? Some would say the subsidiary’s perspective should be used because it will be responsible for administering the project. In addition, since the subsidiary is a subset of the MNC, what is good for the subsidiary would appear to be good for the MNC. This reasoning, however, is not necessarily correct. One could argue that if the parent is ﬁ nancing the project, then it should be evaluating the results from its point of view. The feasibility of the capital budgeting analysis can vary with the perspective because the net after-tax cash inﬂows to the subsidiary can differ substantially from those to the parent. Such differences can be due to several factors, some of which are discussed here.

Tax Differentials H T T P : // http://www.kpmg.com Detailed information on the tax regimes, rates, and regulations of over 75 countries.

If the earnings due to the project will someday be remitted to the parent, the MNC needs to consider how the parent’s government taxes these earnings. If the parent’s government imposes a high tax rate on the remitted funds, the project may be feasible from the subsidiary’s point of view, but not from the parent’s point of view. Under such a scenario, the parent should not consider implementing the project, even though it appears feasible from the subsidiary’s perspective.

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Restricted Remittances Consider a potential project to be implemented in a country where government restrictions require that a percentage of the subsidiary earnings remain in the country. Since the parent may never have access to these funds, the project is not attractive to the parent, although it may be attractive to the subsidiary. One possible solution is to let the subsidiary obtain partial ﬁ nancing for the project within the host country. In this case, the portion of funds not allowed to be sent to the parent can be used to cover the ﬁ nancing costs over time.

Excessive Remittances Consider a parent that charges its subsidiary very high administrative fees because management is centralized at the headquarters. To the subsidiary, the fees represent an expense. To the parent, the fees represent revenue that may substantially exceed the actual cost of managing the subsidiary. In this case, the project’s earnings may appear low from the subsidiary’s perspective and high from the parent’s perspective. The feasibility of the project again depends on perspective. In most cases, neglecting the parent’s perspective will distort the true value of a foreign project.

Exchange Rate Movements When earnings are remitted to the parent, they are normally converted from the subsidiary’s local currency to the parent’s currency. The amount received by the parent is therefore inﬂuenced by the existing exchange rate. If the subsidiary project is assessed from the subsidiary’s perspective, the cash ﬂows forecasted for the subsidiary do not have to be converted to the parent’s currency.

Summary of Factors Exhibit 14.1 illustrates the process from the time earnings are generated by the subsidiary until the parent receives the remitted funds. The exhibit shows how the cash ﬂows of the subsidiary may be reduced by the time they reach the parent. The subsidiary’s earnings are reduced initially by corporate taxes paid to the host government. Then, some of the earnings are retained by the subsidiary (either by the subsidiary’s choice or according to the host government’s rules), with the residual targeted as funds to be remitted. Those funds that are remitted may be subject to a withholding tax by the host government. The remaining funds are converted to the parent’s currency (at the prevailing exchange rate) and remitted to the parent. Given the various factors shown here that can drain subsidiary earnings, the cash ﬂows actually remitted by the subsidiary may represent only a small portion of the earnings it generates. The feasibility of the project from the parent’s perspective is dependent not on the subsidiary’s cash ﬂows but on the cash ﬂows that the parent ultimately receives. The parent’s perspective is appropriate in attempting to determine whether a project will enhance the ﬁ rm’s value. Given that the parent’s shareholders are its owners, it should make decisions that satisfy its shareholders. Each project, whether foreign or domestic, should ultimately generate sufﬁcient cash ﬂows to the parent to enhance shareholder wealth. Any changes in the parent’s expenses should also be included in the analysis. The parent may incur additional expenses for monitoring the new foreign subsidiary’s management or consolidating the subsidiary’s ﬁ nancial statements. Any project that can create a positive net present value for the parent should enhance shareholder wealth. One exception to the rule of using a parent’s perspective occurs when the foreign subsidiary is not wholly owned by the parent and the foreign project is partially ﬁ nanced with retained earnings of the parent and of the subsidiary. In this case, the

Chapter 14: Multinational Capital Budgeting Exhibit 14.1

389

Process of Remitting Subsidiary Earnings to the Parent

Cash Flows Generated by Subsidiary Corporate Taxes Paid to Host Government After-Tax Cash Flows to Subsidiary Retained Earnings by Subsidiary Cash Flows Remitted by Subsidiary Withholding Tax Paid to Host Government After-Tax Cash Flows Remitted by Subsidiary

Conversion of Funds to Parent's Currency Cash Flows to Parent Parent

foreign subsidiary has a group of shareholders that it must satisfy. Any arrangement made between the parent and the subsidiary should be acceptable to the two entities only if the arrangement enhances the values of both. The goal is to make decisions in the interests of both groups of shareholders and not to transfer wealth from one entity to another. Although this exception occasionally occurs, most foreign subsidiaries of MNCs are wholly owned by the parents. Examples in this text implicitly assume that the subsidiary is wholly owned by the parent (unless noted otherwise) and therefore focus on the parent’s perspective.

Input for Multinational Capital Budgeting H T T P : // http:// ﬁnance.yahoo.com/ intlindices?u Information on the recent performance of country stock indexes. This is sometimes used as a general indication of economic conditions in various countries and may be considered by MNCs that assess the feasibility of foreign projects.

Regardless of the long-term project to be considered, an MNC will normally require forecasts of the economic and ﬁ nancial characteristics related to the project. Each of these characteristics is brieﬂy described here: 1. Initial investment. The parent’s initial investment in a project may constitute the major source of funds to support a particular project. Funds initially invested in a project may include not only whatever is necessary to start the project but also additional funds, such as working capital, to support the project over time. Such funds are needed to ﬁ nance inventory, wages, and other expenses until the project begins to generate revenue. Because cash inﬂows will not always be sufﬁcient

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to cover upcoming cash outﬂows, working capital is needed throughout a project’s lifetime. 2. Price and consumer demand. The price at which the product could be sold can be forecasted using competitive products in the markets as a comparison. A longterm capital budgeting analysis requires projections for not only the upcoming period but the expected lifetime of the project as well. The future prices will most likely be responsive to the future inﬂation rate in the host country (where the project is to take place), but the future inﬂation rate is not known. Thus, future inﬂation rates must be forecasted in order to develop projections of the product price over time. When projecting a cash ﬂow schedule, an accurate forecast of consumer demand for a product is quite valuable, but future demand is often difﬁcult to forecast. For example, if the project is a plant in Germany that produces automobiles, the MNC must forecast what percentage of the auto market in Germany it can pull from prevailing auto producers. Once a market share percentage is forecasted, projected demand can be computed. Demand forecasts can sometimes be aided by historical data on the market share other MNCs in the industry pulled when they entered this market, but historical data are not always an accurate indicator of the future. In addition, many projects reﬂect a ﬁ rst attempt, so there are no predecessors to review as an indicator of the future. 3. Costs. Like the price estimate, variable-cost forecasts can be developed from assessing prevailing comparative costs of the components (such as hourly labor costs and the cost of materials). Such costs should normally move in tandem with the future inﬂation rate of the host country. Even if the variable cost per unit can be accurately predicted, the projected total variable cost (variable cost per unit times quantity produced) may be wrong if the demand is inaccurately forecasted. On a periodic basis, the ﬁ xed cost may be easier to predict than the variable cost since it normally is not sensitive to changes in demand. It is, however, sensitive to any change in the host country’s inﬂation rate from the time the forecast is made until the time the ﬁ xed costs are incurred. 4. Tax laws. The tax laws on earnings generated by a foreign subsidiary or remitted to the MNC’s parent vary among countries. Under some circumstances, the MNC receives tax deductions or credits for tax payments by a subsidiary to the host country (see the chapter appendix for more details). Withholding taxes must also be considered if they are imposed on remitted funds by the host government. Because after-tax cash ﬂows are necessary for an adequate capital budgeting analysis, international tax effects must be determined on any proposed foreign projects. 5. Remitted funds. In some cases, a host government will prevent a subsidiary from sending its earnings to the parent. This restriction may reﬂect an attempt to encourage additional local spending or to avoid excessive sales of the local currency in exchange for some other currency. Since the restrictions on fund transfers prevent cash from coming back to the parent, projected net cash ﬂows from the parent’s perspective will be affected. If the parent is aware of these restrictions, it can incorporate them when projecting net cash ﬂows. Sometimes, however, the host government adjusts its restrictions over time; in that case, the MNC can only forecast the future restrictions and incorporate these forecasts into the analysis. 6. Exchange rates. Any international project will be affected by exchange rate ﬂuctuations during the life of the project, but these movements are often very difﬁcult to forecast. There are methods of hedging against them, though most

Chapter 14: Multinational Capital Budgeting

391

hedging techniques are used to cover short-term positions. While it is possible to hedge over longer periods (with long-term forward contracts or currency swap arrangements), the MNC has no way of knowing the amount of funds that it should hedge. This is because it is only guessing at its future costs and revenue due to the project. Thus, the MNC may decide not to hedge the projected foreign currency net cash ﬂows. 7. Salvage (liquidation) value. The after-tax salvage value of most projects is difﬁcult to forecast. It will depend on several factors, including the success of the project and the attitude of the host government toward the project. As an extreme possibility, the host government could take over the project without adequately compensating the MNC. Some projects have indeﬁ nite lifetimes that can be difﬁcult to assess, while other projects have designated speciﬁc lifetimes, at the end of which they will be liquidated. This makes the capital budgeting analysis easier to apply. It should be recognized that the MNC does not always have complete control over the lifetime decision. In some cases, political events may force the ﬁ rm to liquidate the project earlier than planned. The probability that such events will occur varies among countries. 8. Required rate of return. Once the relevant cash ﬂows of a proposed project are estimated, they can be discounted at the project’s required rate of return, which may differ from the MNC’s cost of capital because of that particular project’s risk. An MNC can estimate its cost of capital in order to decide what return it would require in order to approve proposed projects. The manner by which an MNC determines its cost of capital is discussed in Chapter 17.

H T T P : // http:// www.weforum.org Information on global competitiveness and other details of interest to MNCs that implement projects in foreign countries.

Additional considerations will be discussed after a simpliﬁed multinational capital budgeting example is provided. In the real world, magic numbers aren’t provided to MNCs for insertion into their computers. The challenge revolves around accurately forecasting the variables relevant to the project evaluation. If garbage (inaccurate forecasts) is input into the computer, the analysis output by the computer will also be garbage. Consequently, an MNC may take on a project by mistake. Since such a mistake may be worth millions of dollars, MNCs need to assess the degree of uncertainty for any input that is used in the project evaluation. This is discussed more thoroughly later in this chapter.

Multinational Capital Budgeting Example Capital budgeting for the MNC is necessary for all long-term projects that deserve consideration. The projects may range from a small expansion of a subsidiary division to the creation of a new subsidiary. This section presents an example involving the possible development of a new subsidiary. It begins with assumptions that simplify the capital budgeting analysis. Then, additional considerations are introduced to emphasize the potential complexity of such an analysis. This example illustrates one of many possible methods available that would achieve the same result. Also, keep in mind that a real-world problem may involve more extenuating circumstances than those shown here.

Background Spartan, Inc., is considering the development of a subsidiary in Singapore that would manufacture and sell tennis rackets locally. Spartan’s management has asked various departments to supply relevant information for a capital budgeting analysis. In addition, some Spartan executives have met with government ofﬁcials in Singapore to dis-

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cuss the proposed subsidiary. The project would end in 4 years. All relevant information follows. 1. Initial investment. An estimated 20 million Singapore dollars (S$), which includes funds to support working capital, would be needed for the project. Given the existing spot rate of $.50 per Singapore dollar, the U.S. dollar amount of the parent’s initial investment is $10 million. 2. Price and demand. The estimated price and demand schedules during each of the next 4 years are shown here:

Price per Racket Demand in Singapore

Year 1

Year 2

Year 3

Year 4

S$350

S$350

S$360

S$380

60,000 units

60,000 units

100,000 units

100,000 units

3. Costs. The variable costs (for materials, labor, etc.) per unit have been estimated and consolidated as shown here:

Variable Costs per Racket

Year 1

Year 2

Year 3

Year 4

S$200

S$200

S$250

S$260

The expense of leasing extra ofﬁce space is S$1 million per year. Other annual overhead expenses are expected to be S$1 million per year. 4. Depreciation. The Singapore government will allow Spartan’s subsidiary to depreciate the cost of the plant and equipment at a maximum rate of S$2 million per year, which is the rate the subsidiary will use. 5. Taxes. The Singapore government will impose a 20 percent tax rate on income. In addition, it will impose a 10 percent withholding tax on any funds remitted by the subsidiary to the parent. The U.S. government will allow a tax credit on taxes paid in Singapore; therefore, earnings remitted to the U.S. parent will not be taxed by the U.S. government. 6. Remitted funds. The Spartan subsidiary plans to send all net cash ﬂows received back to the parent ﬁ rm at the end of each year. The Singapore government promises no restrictions on the cash ﬂows to be sent back to the parent ﬁ rm but does impose a 10 percent withholding tax on any funds sent to the parent, as mentioned earlier. 7. Salvage value. The Singapore government will pay the parent S$12 million to assume ownership of the subsidiary at the end of 4 years. Assume that there is no capital gains tax on the sale of the subsidiary. 8. Exchange rates. The spot exchange rate of the Singapore dollar is $.50. Spartan uses the spot rate as its best forecast of the exchange rate that will exist in future periods. Thus, the forecasted exchange rate for all future periods is $.50. 9. Required rate of return. Spartan, Inc., requires a 15 percent return on this project.

Analysis The capital budgeting analysis will be conducted from the parent’s perspective, based on the assumption that the subsidiary is intended to generate cash ﬂows that will ultimately be passed on to the parent. Thus, the net present value (NPV ) from the parent’s perspective is based on a comparison of the present value of the cash ﬂows received by the parent to the initial outlay by the parent. As explained earlier in this

Chapter 14: Multinational Capital Budgeting

393

chapter, an international project’s NPV is dependent on whether a parent or subsidiary perspective is used. Since the U.S. parent’s perspective is used, the cash ﬂows of concern are the dollars ultimately received by the parent as a result of the project. The required rate of return is based on the cost of capital used by the parent to make its investment, with an adjustment for the risk of the project. For the establishment of the subsidiary to beneﬁt Spartan’s parent, the present value of future cash ﬂows (including the salvage value) ultimately received by the parent should exceed the parent’s initial outlay. The capital budgeting analysis to determine whether Spartan, Inc., should establish the subsidiary is provided in Exhibit 14.2 (review this exhibit as you read on). The

Exhibit 14.2

Capital Budgeting Analysis: Spartan, Inc. Year 0

Year 1

Year 2

Year 3

Year 4

1.

Demand

60,000

60,000

100,000

100,000

2.

Price per unit

S$350

S$350

S$360

S$380

3.

Total revenue (1) (2)

S$21,000,000

S$21,000,000

S$36,000,000

S$38,000,000

4.

Variable cost per unit

S$200

S$200

S$250

S$260

5.

Total variable cost (1) (4)

S$12,000,000

S$12,000,000

S$25,000,000

S$26,000,000

6.

Annual lease expense

S$1,000,000

S$1,000,000

S$1,000,000

S$1,000,000

7.

Other ﬁxed annual expenses

S$1,000,000

S$1,000,000

S$1,000,000

S$1,000,000

8.

Noncash expense (depreciation)

S$2,000,000

S$2,000,000

S$2,000,000

S$2,000,000

S$16,000,000

S$16,000,000

S$29,000,000

S$30,000,000

Before-tax earnings of subsidiary (3) (9)

S$5,000,000

S$5,000,000

S$7,000,000

S$8,000,000

11.

Host government tax (20%)

S$1,000,000

S$1,000,000

S$1,400,000

S$1,600,000

12.

After-tax earnings of subsidiary

S$4,000,000

S$4,000,000

S$5,600,000

S$6,400,000

Net cash ﬂow to subsidiary (12) (8)

S$6,000,000

S$6,000,000

S$7,600,000

S$8,400,000

S$ remitted by subsidiary (100% of net cash ﬂow)

S$6,000,000

S$6,000,000

S$7,600,000

S$8,400,000

S$600,000

S$600,000

S$760,000

S$840,000

S$5,400,000

S$5,400,000

S$6,840,000

S$7,560,000

9. 10.

13. 14. 15. 16.

Total expenses (5) (6) (7) (8)

Withholding tax on remitted funds (10%) S$ remitted after withholding taxes

17.

Salvage value

18.

Exchange rate of S$

$.50

$.50

$.50

$.50

19.

Cash ﬂows to parent

$2,700,000

$2,700,000

$3,420,000

$9,780,000

20.

PV of parent cash ﬂows (15% discount rate)

$2,347,826

$2,041,588

$2,248,706

$5,591,747

$7,652,174

$5,610,586

$3,361,880

$2,229,867

21.

Initial investment by parent

22.

Cumulative NPV

S$12,000,000

$10,000,000

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ﬁ rst step is to incorporate demand and price estimates in order to forecast total revenue (see lines 1 through 3). Then, the expenses are summed up to forecast total expenses (see lines 4 through 9). Next, before-tax earnings are computed (in line 10) by subtracting total expenses from total revenues. Host government taxes (line 11) are then deducted from before-tax earnings to determine after-tax earnings for the subsidiary (line 12). The depreciation expense is added to the after-tax subsidiary earnings to compute the net cash ﬂow to the subsidiary (line 13). All of these funds are to be remitted by the subsidiary, so line 14 is the same as line 13. The subsidiary can afford to send all net cash ﬂow to the parent since the initial investment provided by the parent includes working capital. The funds remitted to the parent are subject to a 10 percent withholding tax (line 15), so the actual amount of funds to be sent after these taxes is shown in line 16. The salvage value of the project is shown in line 17. The funds to be remitted must ﬁ rst be converted into dollars at the exchange rate (line 18) existing at that time. The parent’s cash ﬂow from the subsidiary is shown in line 19. The periodic funds received from the subsidiary are not subject to U.S. corporate taxes since it was assumed that the parent would receive credit for the taxes paid in Singapore that would offset taxes owed to the U.S. government.

Calculation of NPV. Although several capital budgeting techniques are available, a commonly used technique is to estimate the cash ﬂows and salvage value to be received by the parent and compute the NPV of the project, as shown here: n SVn CFt NPV 5 2IO 1 a t 1 11 1 k2n t51 1 1 1 k 2

where IO initial outlay (investment) CFt cash ﬂow in period t SVn salvage value k required rate of return on the project n lifetime of the project (number of periods) The net cash ﬂow per period (line 19) is discounted at the required rate of return (15 percent rate in this example) to derive the present value (PV) of each period’s net cash ﬂow (line 20). Finally, the cumulative NPV (line 22) is determined by consolidating the discounted cash ﬂows for each period and subtracting the initial investment (in line 21). For example, as of the end of Year 2, the cumulative NPV was $5,610,586. This was determined by consolidating the $2,347,826 in Year 1, the $2,041,588 in Year 2, and subtracting the initial investment of $10,000,000. The cumulative NPV in each period measures how much of the initial outlay has been recovered up to that point by the receipt of discounted cash ﬂows. Thus, it can be used to estimate how many periods it will take to recover the initial outlay. For some projects, the cumulative NPV remains negative in all periods, which suggests that the discounted cash ﬂows never exceed the initial outlay. That is, the initial outlay is never fully recovered. The critical value in line 22 is the one for the last period because it reﬂects the NPV of the project. In our example, the cumulative NPV as of the end of the last period is $2,229,867. Because the NPV is positive, Spartan, Inc., may accept this project if the discount rate of 15 percent has fully accounted for the project’s risk. If the analysis has not yet accounted for risk, however, Spartan may decide to reject the project. The way an MNC can account for risk in capital budgeting is discussed shortly.

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Factors to Consider in Multinational Capital Budgeting The example of Spartan, Inc., ignored a variety of factors that may affect the capital budgeting analysis, such as: • Exchange rate ﬂuctuations • Inﬂation • Financing arrangement • Blocked funds • Uncertain salvage value • Impact of project on prevailing cash ﬂows • Host government incentives • Real options Each of these factors is discussed in turn.

Exchange Rate Fluctuations Recall that Spartan, Inc., uses the Singapore dollar’s current spot rate ($.50) as a forecast for all future periods of concern. The company realizes that the exchange rate will typically change over time, but it does not know whether the Singapore dollar will strengthen or weaken in the future. Though the difﬁculty in accurately forecasting exchange rates is well known, a multinational capital budgeting analysis could at least incorporate other scenarios for exchange rate movements, such as a pessimistic scenario and an optimistic scenario. From the parent’s point of view, appreciation of the Singapore dollar would be favorable since the Singapore dollar inﬂows would someday be converted to more U.S. dollars. Conversely, depreciation would be unfavorable since the weakened Singapore dollars would convert to fewer U.S. dollars over time. Exhibit 14.3 illustrates both a weak Singapore dollar (weak-S$) scenario and a strong Singapore dollar (strong-S$) scenario. At the top of the table, the anticipated after-tax Singapore dollar cash ﬂows (including salvage value) are shown for the subsidiary from lines 16 and 17 in Exhibit 14.2. The amount in U.S. dollars that these Singapore dollars convert to depends on the exchange rates existing in the various periods when they are converted. The number of Singapore dollars multiplied by the forecasted exchange rate will determine the estimated number of U.S. dollars received by the parent. Notice from Exhibit 14.3 how the cash ﬂows received by the parent differ depending on the scenario. A strong Singapore dollar is clearly beneﬁcial, as indicated by the increased U.S. dollar value of the cash ﬂows received. The large differences in cash ﬂows received by the parent in the different scenarios illustrate the impact of exchange rate expectations on the feasibility of an international project. The NPV forecasts based on projections for exchange rates are illustrated in Exhibit 14.4. The estimated NPV is highest if the Singapore dollar is expected to strengthen and lowest if it is expected to weaken. The estimated NPV is negative for the weak-S$ scenario but positive for the stable-S$ and strong-S$ scenarios. This project’s true feasibility would depend on the probability distribution of these three scenarios for the Singapore dollar during the project’s lifetime. If there is a high probability that the weak-S$ scenario will occur, this project should not be accepted. Some U.S.-based MNCs consider projects in countries where the local currency is tied to the dollar. They may conduct a capital budgeting analysis that presumes the

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Exhibit 14.3

Analysis Using Different Exchange Rate Scenarios: Spartan, Inc. Year 0

Year 1

Year 2

Year 3

Year 4

S$5,400,000

S$5,400,000

S$6,840,000

S$19,560,000

Exchange rate of S$

$.54

$.57

$.61

$.65

Cash ﬂows to parent

$2,916,000

$3,078,000

$4,172,400

$12,714,000

PV of cash ﬂows (15% discount rate)

$2,535,652

$2,327,410

$2,743,421

$7,269,271

$7,464,348

$5,136,938

$2,393,517

$4,875,754

Exchange rate of S$

$.47

$.45

$.40

$.37

Cash ﬂows to parent

$2,538,000

$2,430,000

$2,736,000

$7,237,200

PV of cash ﬂows (15% discount rate)

$2,206,957

$1,837,429

$1,798,964

$4,137,893

$7,793,043

$5,955,614

$4,156,650

$18,757

S$ remitted after withholding taxes (including salvage value) Strong-S$ Scenario

Initial investment by parent

$10,000,000

Cumulative NPV Weak-S$ Scenario

Initial investment by parent

$10,000,000

Cumulative NPV

exchange rate will remain ﬁ xed. It is possible, however, that the local currency will be devalued at some point in the future, which could have a major impact on the cash ﬂows to be received by the parent. Therefore, the MNC may reestimate the project’s NPV based on a particular devaluation scenario that it believes could possibly occur. If the project is still feasible under this scenario, the MNC may be more comfortable pursuing the project.

Inflation Capital budgeting analysis implicitly considers inﬂation, since variable cost per unit and product prices generally have been rising over time. In some countries, inﬂation can be quite volatile from year to year and can therefore strongly inﬂuence a project’s net cash ﬂows. In countries where the inﬂation rate is high and volatile, it will be virtually impossible for a subsidiary to accurately forecast inﬂation each year. Inaccurate inﬂation forecasts can lead to inaccurate net cash ﬂow forecasts. Although ﬂuctuations in inﬂation should affect both costs and revenues in the same direction, the magnitude of their changes may be very different. This is especially true when the project involves importing partially manufactured components and selling the ﬁ nished product locally. The local economy’s inﬂation will most likely have a stronger impact on revenues than on costs in such cases. The joint impact of inﬂation and exchange rate ﬂuctuations on a subsidiary’s net cash ﬂows may produce a partial offsetting effect from the viewpoint of the parent. The exchange rates of highly inﬂated countries tend to weaken over time. Thus, even if subsidiary earnings are inﬂated, they will be deﬂated when converted into the parent’s home currency (if the subsidiary’s currency has weakened). Such an offsetting effect is not exact or consistent, though. Because inﬂation is only one of many factors that inﬂuence exchange rates, there is no guarantee that a currency will depreciate

Chapter 14: Multinational Capital Budgeting Exhibit 14.4 Spartan, Inc.

Sensitivity of the Project’s NPV to Different Exchange Rate Scenarios:

Strong S$

$4,875,754

NPV

397

Stable S$ $2,229,867

– $18,757

Weak S$

Value of Singapore Dollar (S$)

when the local inﬂation rate is relatively high. Therefore, one cannot ignore the impact of inﬂation and exchange rates on net cash ﬂows.

Financing Arrangement Many foreign projects are partially ﬁ nanced by foreign subsidiaries. To illustrate how this foreign ﬁ nancing can inﬂuence the feasibility of the project, consider the following revisions in the example of Spartan, Inc.

Subsidiary Financing. Assume that the subsidiary borrows S$10 million to purchase the ofﬁces that are leased in the initial example. Assume that the subsidiary will make interest payments on this loan (of S$1 million) annually and will

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pay the principal (S$10 million) at the end of Year 4, when the project is terminated. Since the Singapore government permits a maximum of S$2 million per year in depreciation for this project, the subsidiary’s depreciation rate will remain unchanged. Assume the ofﬁces are expected to be sold for S$10 million after taxes at the end of Year 4. Domestic capital budgeting problems would not include debt payments in the measurement of cash ﬂows because all ﬁ nancing costs are captured by the discount rate. Foreign projects are more complicated, however, especially when the foreign subsidary partially ﬁ nances the investment in the foreign project. Although consolidating the initial investments made by the parent and the subsidiary simpliﬁes the capital budgeting process, it can cause signiﬁcant estimation errors. The estimated foreign cash ﬂows that are ultimately remitted to the parent and are subject to exchange rate risk will be overstated if the foreign interest expenses are not explicitly considered as cash outﬂows for the foreign subsidiary. Thus, a more accurate approach is to separate the investment made by the subsidiary from the investment made by the parent. The capital budgeting analysis can focus on the parent’s perspective by comparing the present value of the cash ﬂows received by the parent to the initial investment by the parent. Given the revised assumptions, the following revisions must be made to the capital budgeting analysis: 1. Since the subsidiary is borrowing funds to purchase the ofﬁces, the lease payments of S$1 million per year will not be necessary. However, the subsidiary will pay interest of S$1 million per year as a result of the loan. Thus, the annual cash outﬂows for the subsidiary are still the same. 2. The subsidiary must pay the S$10 million in loan principal at the end of 4 years. However, since the subsidiary expects to receive S$10 million (in 4 years) from the sale of the offices it purchases with the funds provided by the loan, it can use the proceeds of the sale to pay the loan principal. Since the subsidiary has already taken the maximum depreciation expense allowed by the Singapore government before the ofﬁces were considered, it cannot increase its annual depreciation expenses. In this example, the cash ﬂows ultimately received by the parent when the subsidiary obtains ﬁ nancing to purchase ofﬁces are similar to the cash ﬂows determined in the original example (when the ofﬁces are to be leased). If the numbers were not offsetting, the capital budgeting analysis would be repeated to determine whether the NPV from the parent’s perspective is higher than in the initial example.

Parent Financing. Consider one more alternative arrangement, in which, instead of the subsidiary leasing the ofﬁces or purchasing them with borrowed funds, the parent uses its own funds to purchase the ofﬁces. Thus, its initial investment is $15 million, composed of the original $10 million investment as explained earlier, plus an additional $5 million to obtain an extra S$10 million to purchase the ofﬁces. This example illustrates how the capital budgeting analysis changes when the parent takes a bigger stake in the investment. If the parent rather than the subsidiary purchases the ofﬁces, the following revisions must be made to the capital budgeting analysis: 1. The subsidiary will not have any loan payments (since it will not need to borrow funds) because the parent will purchase the ofﬁces. Since the ofﬁces are to be purchased, there will be no lease payments either. 2. The parent’s initial investment is $15 million instead of $10 million.

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3. The salvage value to be received by the parent is S$22 million instead of S$12 million because the offices are assumed to be sold for S$10 million after taxes at the end of Year 4. The S$10 million to be received from selling the offices can be added to the S$12 million to be received from selling the rest of the subsidiary. The capital budgeting analysis for Spartan, Inc., under this revised ﬁ nancing strategy in which the parent ﬁ nances the entire $15 million investment is shown in Exhibit 14.5. This analysis uses our original exchange rate projections of $.50 per

Exhibit 14.5

Analysis with an Alternative Financing Arrangement: Spartan, Inc. Year 0

Year 1

Year 2

Year 3

Year 4

1. Demand

60,000

60,000

100,000

100,000

2. Price per unit

S$350

S$350

S$360

S$380

S$21,000,000

S$21,000,000

S$36,000,000

S$38,000,000

S$200

S$200

S$250

S$260

S$12,000,000

S$12,000,000

S$25,000,000

S$26,000,000

[S$0]

[S$0]

[S$0]

[S$0]

7. Other ﬁxed annual expenses

S$1,000,000

S$1,000,000

S$1,000,000

S$1,000,000

8. Noncash expense (depreciation)

S$2,000,000

S$2,000,000

S$2,000,000

S$2,000,000

S$15,000,000

S$15,000,000

S$28,000,000

S$29,000,000

10. Before-tax earnings of subsidiary (3) (9)

S$6,000,000

S$6,000,000

S$8,000,000

S$9,000,000

11.

S$1,200,000

S$1,200,000

S$1,600,000

S$1,800,000

12. After-tax earnings of subsidiary

S$4,800,000

S$4,800,000

S$6,400,000

S$7,200,000

13. Net cash ﬂow to subsidiary (12) (8)

S$6,800,000

S$6,800,000

S$8,400,000

S$9,200,000

14. S$ remitted by subsidiary (100% of S$)

S$6,800,000

S$6,800,000

S$8,400,000

S$9,200,000

S$680,000

S$680,000

S$840,000

S$920,000

S$6,120,000

S$6,120,000

S$7,560,000

S$8,280,000

3. Total revenue (1) (2) 4. Variable cost per unit 5. Total variable cost (1) (4) 6. Annual lease expense

9. Total expenses (5) (6) (7) (8)

Host government tax (20%)

15. Withholding tax on remitted funds (10%) 16. S$ remitted after withholding taxes 17.

Salvage value

[S$22,000,000]

18. Exchange rate of S$

$.50

$.50

$.50

$.50

19. Cash ﬂows to parent

$3,060,000

$3,060,000

$3,780,000

$15,140,000

20. PV of parent cash ﬂows (15% discount rate)

$2,660,870

$2,313,800

$2,485,411

$8,656,344

$12,339,130

$10,025,330

$7,539,919

$1,116,425

21. Initial investment by parent 22. Cumulative NPV

[$15,000,000]

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Singapore dollar for each period. The numbers that are directly affected by the revised ﬁ nancing arrangement are bracketed. Other numbers are also affected indirectly as a result. For example, the subsidiary’s after-tax earnings increase as a result of avoiding interest or lease payments on its ofﬁces. The NPV of the project under this alternative ﬁ nancing arrangement is positive but less than in the original arrangement. Given the higher initial outlay of the parent and the lower NPV, this arrangement is not as feasible as the arrangement in which the subsidiary either leases the ofﬁces or purchases them with borrowed funds.

Comparison of Parent versus Subsidiary Financing. One reason that the subsidiary ﬁ nancing is more feasible than complete parent ﬁ nancing is that the ﬁ nancing rate on the loan is lower than the parent’s required rate of return on funds provided to the subsidiary. If local loans had a relatively high interest rate, however, the use of local ﬁ nancing would likely not be as attractive. In general, this revised example shows that the increased investment by the parent increases the parent’s exchange rate exposure for the following reasons. First, since the parent provides the entire investment, no foreign ﬁ nancing is required. Consequently, the subsidiary makes no interest payments and therefore remits larger cash ﬂows to the parent. Second, the salvage value to be remitted to the parent is larger. Given the larger payments to the parent, the cash ﬂows ultimately received by the parent are more susceptible to exchange rate movements. The parent’s exposure is not as large when the subsidiary purchases the ofﬁces because the subsidiary incurs some of the ﬁ nancing expenses. The subsidiary ﬁ nancing essentially shifts some of the expenses to the same currency that the subsidiary will receive and therefore reduces the amount that will ultimately be converted into dollars for remittance to the parent. Financing with Other Subsidiaries’ Retained Earnings. Some foreign projects are completely ﬁ nanced with retained earnings of existing foreign subsidiaries. These projects are difﬁcult to assess from the parent’s perspective because their direct effects are normally felt by the subsidiaries. One approach is to view a subsidiary’s investment in a project as an opportunity cost, since the funds could be remitted to the parent rather than invested in the foreign project. Thus, the initial outlay from the parent’s perspective is the amount of funds it would have received from the subsidiary if the funds had been remitted rather than invested in this project. The cash ﬂows from the parent’s perspective reﬂect those cash ﬂows ultimately received by the parent as a result of the foreign project. Even if the project generates earnings for the subsidiary that are reinvested by the subsidiary, the key cash ﬂows from the parent’s perspective are those that it ultimately receives from the project. In this way, any international factors that will affect the cash ﬂows (such as withholding taxes and exchange rate movements) are incorporated into the capital budgeting process.

Blocked Funds In some cases, the host country may block funds that the subsidiary attempts to send to the parent. Some countries require that earnings generated by the subsidiary be reinvested locally for at least 3 years before they can be remitted. Such restrictions can affect the accept/reject decision on a project.

E X A M P L E

Reconsider the example of Spartan, Inc., assuming that all funds are blocked until the subsidiary is sold. Thus, the subsidiary must reinvest those funds until that time.

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Blocked funds penalize a project if the return on the reinvested funds is less than the required rate of return on the project. Assume that the subsidiary uses the funds to purchase marketable securities that are expected to yield 5 percent annually after taxes. A reevaluation of Spartan’s cash flows (from Exhibit 14.2) to incorporate the blocked-funds restriction is shown in Exhibit 14.6. The withholding tax is not applied until the funds are remitted to the parent, which is in Year 4. The original exchange rate projections are used here. All parent cash flows depend on the exchange rate 4 years from now. The NPV of the project with blocked funds is still positive, but it is substantially less than the NPV in the original example. If the foreign subsidiary has a loan outstanding, it may be able to better utilize the blocked funds by repaying the local loan. For example, the S$6 million at the end of Year 1 could be used to reduce the outstanding loan balance instead of being invested in marketable securities, assuming that the lending bank allows early repayment. ■

There may be other situations that deserve to be considered in multinational capital budgeting, such as political conditions in the host country and restrictions that may be imposed by a country’s host government. These country risk characteristics are discussed in more detail in Chapter 16.

Uncertain Salvage Value The salvage value of an MNC’s project typically has a signiﬁcant impact on the project’s NPV. When the salvage value is uncertain, the MNC may incorporate various possible outcomes for the salvage value and reestimate the NPV based on each possible outcome. It may even estimate the break-even salvage value (also called breakeven terminal value), which is the salvage value necessary to achieve a zero NPV for the project. If the actual salvage value is expected to equal or exceed the break-even salvage value, the project is feasible. The break-even salvage value (called SVn) can Exhibit 14.6

Capital Budgeting with Blocked Funds: Spartan, Inc. Year 0

S$ to be remitted by subsidiary

Year 1

S$6,000,000

Year 2

S$6,000,000

Year 3

S$7,600,000

Year 4

S$8,400,000 S$7,980,000

S$ accumulated by reinvesting funds to be remitted

S$6,615,000 S$6,945,750 S$29,940,750

Withholding tax (10%)

S$2,994,075

S$ remitted after withholding tax

S$26,946,675

Salvage value

S$12,000,000

Exchange rate

$.50

Cash ﬂows to parent

$19,473,338

PV of parent cash ﬂows (15% discount rate)

$11,133,944

Initial investment by parent Cumulative NPV

$10,000,000 $10,000,000

$10,000,000

$10,000,000

$1,133,944

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be determined by setting NPV equal to zero and rearranging the capital budgeting equation, as follows: n SVn CFt NPV 5 2IO 1 a t 1 1 2 1 1 1 k2n t51 1 1 k n SVn CFt 0 5 2IO 1 a t 1 1 2 1 1 1 k 1 1 k2n t51 n CFt SVn IO 2 a t 5 1 2 1 1 1 k 1 1 k2n t51 n CFt cIO 2 a d 1 1 1 k 2 n 5 SVn 1 1 1 k2t t51

Reconsider the Spartan, Inc., example and assume that Spartan is not guaranteed a price for the project. The break-even salvage value for the project can be determined by (1) estimating the present value of future cash flows (excluding the salvage value), (2) subtracting the discounted cash flows from the initial outlay, and (3) multiplying the difference times (1 k) n. Using the original cash flow information from Exhibit 14.2, the present value of cash flows can be determined:

E X A M P L E

PV of parent cash flows 5

$2,700,000 $2,700,000 $3,420,000 $3,780,000 1 1 1 1 1.15 2 1 1 1.15 2 2 1 1.15 2 3 1 1.15 2 4

5 $2,347,826 1 $2,041,588 1 $2,248,706 1 $2,161,227 5 $8,799,347 Given the present value of cash flows and the estimated initial outlay, the break-even salvage value is determined this way:

CFt SVn 5 cIO 2 a d 11 1 k2n 11 1 k2t

5 1 $10,000,000 2 $8,799,347 2 1 1.15 2 4 5 $2,099,950

Given the original information in Exhibit 14.2, Spartan, Inc., will accept the project only if the salvage value is estimated to be at least $2,099,950 (assuming that the project’s required rate of return is 15 percent). Assuming the forecasted exchange rate of $.50 per Singapore dollar (2 Singapore dollars per U.S. dollar), the project must sell for more than S$4,199,900 (computed as $2,099,950 divided by $.50) to exhibit a positive NPV (assuming no taxes are paid on this amount). If Spartan did not have a guarantee from the Singapore government, it could assess the probability that the subsidiary would sell for more than the break-even salvage value and then incorporate this assessment into its decision to accept or reject the project. ■

Impact of Project on Prevailing Cash Flows Thus far, in our example, we have assumed that the new project has no impact on prevailing cash ﬂows. In reality, however, there may often be an impact. Reconsider the Spartan, Inc., example, assuming this time that (1) Spartan currently exports tennis rackets from its U.S. plant to Singapore; (2) Spartan, Inc., still considers establishing a subsidiary in Singapore because it expects production costs to be lower in Sin-

E X A M P L E

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403

gapore than in the United States; and (3) without a subsidiary, Spartan’s export business to Singapore is expected to generate net cash flows of $1 million over the next 4 years. With a subsidiary, these cash flows would be forgone. The effects of these assumptions are shown in Exhibit 14.7. The previously estimated cash flows to the parent from the subsidiary (drawn from Exhibit 14.2) are restated in Exhibit 14.7. These estimates do not account for forgone cash flows since the possible export business was not considered. If the export business is established, however, the forgone cash flows attributable to this business must be considered, as shown in Exhibit 14.7. The adjusted cash flows to the parent account for the project’s impact on prevailing cash flows. The present value of adjusted cash flows and cumulative NPV are also shown in Exhibit 14.7. The project’s NPV is now negative as a result of the adverse effect on prevailing cash flows. Thus, the project will not be feasible if the exporting business to Singapore is eliminated. ■

Some foreign projects may have a favorable impact on prevailing cash ﬂows. For example, if a manufacturer of computer components establishes a foreign subsidiary to manufacture computers, the subsidiary might order the components from the parent. In this case, the sales volume of the parent would increase.

Host Government Incentives Foreign projects proposed by MNCs may have a favorable impact on economic conditions in the host country and are therefore encouraged by the host government. Any incentives offered by the host government must be incorporated into the capital budgeting analysis. For example, a low-rate host government loan or a reduced tax rate offered to the subsidiary will enhance periodic cash ﬂows. If the government subsidizes the initial establishment of the subsidiary, the MNC’s initial investment will be reduced.

Real Options A real option is an option on speciﬁed real assets such as machinery or a facility. Some capital budgeting projects contain real options in that they may allow opportunities to obtain or eliminate real assets. Since these opportunities can generate cash ﬂows, they can enhance the value of a project.

Exhibit 14.7

Capital Budgeting When Prevailing Cash Flows Are Affected: Spartan, Inc. Year 0

Year 1

Year 2

Year 3

Year 4

Cash ﬂows to parent, ignoring impact on prevailing cash ﬂows

$2,700,000

$2,700,000

$3,420,000

$9,780,000

Impact of project on prevailing cash ﬂows

$1,000,000

$1,000,000

$1,000,000

$1,000,000

Cash ﬂows to parent, incorporating impact on prevailing cash ﬂows

$1,700,000

$1,700,000

$2,420,000

$8,780,000

PV of cash ﬂows to parent (15% discount rate)

$1,478,261

$1,285,444

$1,591,189

$5,019,994

$8,521,739

$7,236,295

$5,645,106

$625,112

Initial investment Cumulative NPV

$10,000,000

404

Part 4: Long-Term Asset and Liability Management Reconsider the Spartan example and assume that the government in Singapore promised that if Spartan established the subsidiary to produce tennis rackets in Singapore, it would be allowed to purchase some government buildings at a future point in time at a discounted price. This offer does not directly affect the cash flows of the project that is presently being assessed, but it reflects an implicit call option that Spartan could exercise in the future. In some cases, real options can be very valuable and may encourage MNCs to accept a project that they would have rejected without the real option. ■

E X A M P L E

The value of a real option within a project is primarily inﬂuenced by two factors: (1) the probability that the real option will be exercised and (2) the NPV that will result from exercising the real option. In the previous example, Spartan’s real option is inﬂuenced by (1) the probability that Spartan will capitalize on the opportunity to purchase government builds at a discount, and (2) the NPV that would be generated from this opportunity.

Adjusting Project Assessment for Risk If an MNC is unsure of the estimated cash ﬂows of a proposed project, it needs to incorporate an adjustment for this risk. Three methods are commonly used to adjust the evaluation for risk: • Risk-adjusted discount rate • Sensitivity analysis • Simulation Each method is described in turn.

Risk-Adjusted Discount Rate The greater the uncertainty about a project’s forecasted cash ﬂows, the larger should be the discount rate applied to cash ﬂows, other things being equal. This risk-adjusted discount rate tends to reduce the worth of a project by a degree that reﬂects the risk the project exhibits. This approach is easy to use, but it is criticized for being somewhat arbitrary. In addition, an equal adjustment to the discount rate over all periods does not reﬂect differences in the degree of uncertainty from one period to another. If the projected cash ﬂows among periods have different degrees of uncertainty, the risk adjustment of the cash ﬂows should vary also. Consider a country where the political situation is slowly destabilizing. The probability of blocked funds, expropriation, and other adverse events is increasing over time. Thus, cash ﬂows sent to the parent are less certain in the distant future than they are in the near future. A different discount rate should therefore be applied to each period in accordance with its corresponding risk. Even so, the adjustment will be subjective and may not accurately reﬂect the risk. Despite its subjectivity, the risk-adjusted discount rate is a commonly used technique, perhaps because of the ease with which it can be arbitrarily adjusted. In addition, there is no alternative technique that will perfectly adjust for risk, although in certain cases some others (discussed next) may better reﬂect a project’s risk.

Sensitivity Analysis Once the MNC has estimated the NPV of a proposed project, it may want to consider alternative estimates for its input variables.

E X A M P L E

Recall that the demand for the Spartan subsidiary’s tennis rackets (in our earlier example) was estimated to be 60,000 in the first 2 years and 100,000 in the next 2 years. If

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demand turns out to be 60,000 in all 4 years, how will the NPV results change? Alternatively, what if demand is 100,000 in all 4 years? Use of such what-if scenarios is referred to as sensitivity analysis. The objective is to determine how sensitive the NPV is to alternative values of the input variables. The estimates of any input variables can be revised to create new estimates for NPV. If the NPV is consistently positive during these revisions, then the MNC should feel more comfortable about the project. If it is negative in many cases, the accept/reject decision for the project becomes more difficult. ■

The two exchange rate scenarios developed earlier represent a form of sensitivity analysis. Sensitivity analysis can be more useful than simple point estimates because it reassesses the project based on various circumstances that may occur. Many computer software packages are available to perform sensitivity analysis.

Simulation Simulation can be used for a variety of tasks, including the generation of a probability distribution for NPV based on a range of possible values for one or more input variables. Simulation is typically performed with the aid of a computer package.

Reconsider Spartan, Inc., and assume that it expects the exchange rate to depreciate by 3 to 7 percent per year (with an equal probability of all values in this range occurring). Unlike a single point estimate, simulation can consider the range of possibilities for the Singapore dollar’s exchange rate at the end of each year. It considers all point estimates for the other variables and randomly picks one of the possible values of the Singapore dollar’s depreciation level for each of the 4 years. Based on this random selection process, the NPV is determined. The procedure just described represents one iteration. Then the process is repeated: The Singapore dollar’s depreciation for each year is again randomly selected (within the range of possibilities assumed earlier), and the NPV of the project is computed. The simulation program may be run for, say, 100 iterations. This means that 100 different possible scenarios are created for the possible exchange rates of the Singapore dollar during the 4-year project period. Each iteration reflects a different scenario. The NPV of the project based on each scenario is then computed. Thus, simulation generates a distribution of NPVs for the project. The major advantage of simulation is that the MNC can examine the range of possible NPVs that may occur. From the information, it can determine the probability that the NPV will be positive or greater than a particular level. The greater the uncertainty of the exchange rate, the greater will be the uncertainty of the NPV. The risk of a project will be greater if it involves transactions in more volatile currencies, other things being equal. ■

E X A M P L E

In reality, many or all of the input variables necessary for multinational capital budgeting may be uncertain in the future. Probability distributions can be developed for all variables with uncertain future values. The ﬁ nal result is a distribution of possible NPVs that might occur for the project. The simulation technique does not put all of its emphasis on any one particular NPV forecast but instead provides a distribution of the possible outcomes that may occur. The project’s cost of capital can be used as a discount rate when simulation is performed. The probability that the project will be successful can be estimated by measuring the area within the probability distribution in which the NPV 0. This area represents the probability that the present value of future cash ﬂows will exceed the initial outlay. An MNC can also use the probability distribution to estimate the probability that the project will backﬁ re by measuring the area in which NPV 0. Simulation is difﬁcult to do manually because of the iterations necessary to develop a distribution of NPVs. Computer programs can run 100 iterations and generate results within a matter of seconds. The user of a simulation program must provide

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the probability distributions for the input variables that will affect the project’s NPV. As with any model, the accuracy of results generated by simulation will be dependent on the accuracy of the input. Controls over International Project Proposals The feasibility of a project proposed by managers of an MNC is highly dependent on their estimates of revenue and cost-related cash flows. To the extent that managers are rewarded based on sales growth within their division, they may be tempted to exaggerate their estimates of cash inflows in order to ensure that their projects are approved. Proper governance can prevent this type of agency problem. First, the estimates should be thoroughly examined to determine whether they are reasonable. Second, a project’s feasibility can be assessed after it has been implemented to determine whether the estimated cash flows by managers were reasonably accurate. However, many international projects are irreversible, so an ideal control system would assess the proposal closely before investing the funds in the project. ■

GOVE ER RN NA AN NC CE E

SUMMARY ■ Capital budgeting may generate different results and a different conclusion depending on whether it is conducted from the perspective of an MNC’s subsidiary or from the perspective of the MNC’s parent. The subsidiary’s perspective does not consider possible exchange rate and tax effects on cash ﬂows transferred by the subsidiary to the parent. When a parent is deciding whether to implement an international project, it should determine whether the project is feasible from its own perspective. ■ Multinational capital budgeting requires any input that will help estimate the initial outlay, periodic cash ﬂows, salvage value, and required rate of return on the project. Once these factors are estimated, the international project’s net present value can be estimated, just as if it were a domestic project. However, it is normally more difﬁcult to estimate these factors

POINT

for an international project. Exchange rates create an additional source of uncertainty because they affect the cash ﬂows ultimately received by the parent as a result of the project. Other international conditions that can inﬂuence the cash ﬂows ultimately received by the parent include the ﬁ nancing arrangement (parent versus subsidiary ﬁ nancing of the project), blocked funds by the host government, and host government incentives. ■ The risk of international projects can be accounted for by adjusting the discount rate used to estimate the project’s net present value. However, the adjustment to the discount rate is subjective. An alternative method is to estimate the net present value based on various possible scenarios for exchange rates or any other uncertain factors. This method is facilitated by the use of sensitivity analysis or simulation.

COUNTER-POINT

Should MNCs Use Forward Rates to Estimate Dollar Cash Flows of Foreign Projects? Point Yes. An MNC’s parent should use the forward rate for each year in which it will receive net cash ﬂows in a foreign currency. The forward rate is market determined and serves as a useful forecast for future years. Counter-Point No. An MNC should use its own forecasts for each year in which it will receive net cash ﬂows in a foreign currency. If the forward rates for fu-

ture time periods are higher than the MNC’s expected spot rates, the MNC may accept a project that it should not accept. Who Is Correct? Use the Internet to learn more about this issue. Which argument do you support? Offer your own opinion on this issue.

Chapter 14: Multinational Capital Budgeting

SELF

407

TEST

Answers are provided in Appendix A at the back of the text. 1. Two managers of Marshall, Inc., assessed a proposed project in Jamaica. Each manager used exactly the same estimates of the earnings to be generated by the project, as these estimates were provided by other employees. The managers agree on the proportion of funds to be remitted each year, the life of the project, and the discount rate to be applied. Both managers also assessed the project from the U.S. parent’s perspective. Nevertheless, one manager determined that this project had a large net present value, while the other manager determined that the project had a negative net present value. Explain the possible reasons for such a difference. 2. Pinpoint the parts of a multinational capital budgeting analysis for a proposed sales distribution center in Ireland that are sensitive when the forecast of a stable economy in Ireland is revised to predict a recession. 3. New Orleans Exporting Co. produces small computer components, which are then sold to Mexico. It plans to expand by establishing a plant in Mexico that will produce the components and sell them locally. This plant will reduce the amount of goods that are transported from New Orleans. The ﬁ rm has determined that the cash ﬂows to be earned in Mexico would yield a positive net present value after

QUESTIONS

AND

accounting for tax and exchange rate effects, converting cash ﬂows to dollars, and discounting them at the proper discount rate. What other major factor must be considered to estimate the project’s NPV ? 4. Explain how the present value of the salvage value of an Indonesian subsidiary will be affected (from the U.S. parent’s perspective) by (a) an increase in the risk of the foreign subsidiary and (b) an expectation that Indonesia’s currency (rupiah) will depreciate against the dollar over time. 5. Wilmette Co. and Niles Co. (both from the United States) are assessing the acquisition of the same ﬁ rm in Thailand and have obtained the future cash ﬂow estimates (in Thailand’s currency, baht) from the ﬁ rm. Wilmette would use its retained earnings from U.S. operations to acquire the subsidiary. Niles Co. would ﬁ nance the acquisition mostly with a term loan (in baht) from Thai banks. Neither ﬁ rm has any other business in Thailand. Which ﬁ rm’s dollar cash ﬂows would be affected more by future changes in the value of the baht (assuming that the Thai ﬁ rm is acquired)? 6. Review the capital budgeting example of Spartan, Inc., discussed in this chapter. Identify the speciﬁc variables assessed in the process of estimating a foreign project’s net present value (from a U.S. perspective) that would cause the most uncertainty about the NPV.

A P P L I CAT I O N S

1. MNC Parent’s Perspective. Why should capital budgeting for subsidiary projects be assessed from the parent’s perspective? What additional factors that normally are not relevant for a purely domestic project deserve consideration in multinational capital budgeting? 2. Accounting for Risk. What is the limitation of using point estimates of exchange rates in the capital budgeting analysis? List the various techniques for adjusting risk in multinational capital budgeting. Describe any advantages or disadvantages of each technique. Explain how simulation can be used in multinational capital budgeting. What can it do that other risk adjustment techniques cannot?

3. Uncertainty of Cash Flows. Using the capital budgeting framework discussed in this chapter, explain the sources of uncertainty surrounding a proposed project in Hungary by a U.S. ﬁ rm. In what ways is the estimated net present value of this project more uncertain than that of a similar project in a more developed European country? 4. Accounting for Risk. Your employees have estimated the net present value of project X to be $1.2 million. Their report says that they have not accounted for risk, but that with such a large NPV, the project should be accepted since even a riskadjusted NPV would likely be positive. You have the ﬁ nal decision as to whether to accept or reject the project. What is your decision?

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5. Impact of Exchange Rates on NPV. a. Describe in general terms how future apprecia-

tion of the euro will likely affect the value (from the parent’s perspective) of a project established in Germany today by a U.S.-based MNC. Will the sensitivity of the project value be affected by the percentage of earnings remitted to the parent each year? b. Repeat this question, but assume the future de-

preciation of the euro. 6. Impact of Financing on NPV. Explain how the ﬁnancing decision can inﬂuence the sensitivity of the net present value to exchange rate forecasts. 7. September 11 Effects on NPV. In August 2001, Woodsen, Inc., of Pittsburgh, Pennsylvania, considered the development of a large subsidiary in Greece. In response to the September 11, 2001, terrorist attack on the United States, its expected cash ﬂows and earnings from this acquisition were reduced only slightly. Yet, the ﬁ rm decided to retract its offer because of an increase in its required rate of return on the project, which caused the NPV to be negative. Explain why the required rate of return on its project may have increased after the attack. 8. Assessing a Foreign Project. Huskie Industries, a U.S.-based MNC, considers purchasing a small manufacturing company in France that sells products only within France. Huskie has no other existing business in France and no cash ﬂows in euros. Would the proposed acquisition likely be more feasible if the euro is expected to appreciate or depreciate over the long run? Explain. 9. Relevant Cash Flows in Disney’s French Theme Park. When Walt Disney World considered establishing a theme park in France, were the forecasted revenues and costs associated with the French park sufﬁcient to assess the feasibility of this project? Were there any other “relevant cash ﬂows” that deserved to be considered? 10. Capital Budgeting Logic. Athens, Inc., established a subsidiary in the United Kingdom that was independent of its operations in the United States. The subsidiary’s performance was well above what was expected. Consequently, when a British ﬁ rm approached Athens about the possibility of acquiring the subsidiary, Athens’ chief ﬁ nancial ofﬁcer implied that the subsidiary was performing so well that it was not for sale. Comment on this strategy. 11. Capital Budgeting Logic. Lehigh Co. established a subsidiary in Switzerland that was performing below the cash ﬂow projections developed before the subsidiary was established. Lehigh anticipated that future cash ﬂows would also be lower than the original cash ﬂow projections. Consequently,

Lehigh decided to inform several potential acquiring ﬁ rms of its plan to sell the subsidiary. Lehigh then received a few bids. Even the highest bid was very low, but Lehigh accepted the offer. It justiﬁed its decision by stating that any existing project whose cash ﬂows are not sufﬁcient to recover the initial investment should be divested. Comment on this statement. 12. Impact of Reinvested Foreign Earnings on NPV. Flagstaff Corp. is a U.S.-based ﬁ rm with a subsidiary in Mexico. It plans to reinvest its earnings in Mexican government securities for the next 10 years since the interest rate earned on these securities is so high. Then, after 10 years, it will remit all accumulated earnings to the United States. What is a drawback of using this approach? (Assume the securities have no default or interest rate risk.) 13. Capital Budgeting Example. Brower, Inc., just constructed a manufacturing plant in Ghana. The construction cost 9 billion Ghanian cedi. Brower intends to leave the plant open for 3 years. During the 3 years of operation, cedi cash ﬂows are expected to be 3 billion cedi, 3 billion cedi, and 2 billion cedi, respectively. Operating cash ﬂows will begin one year from today and are remitted back to the parent at the end of each year. At the end of the third year, Brower expects to sell the plant for 5 billion cedi. Brower has a required rate of return of 17 percent. It currently takes 8,700 cedi to buy one U.S. dollar, and the cedi is expected to depreciate by 5 percent per year. a. Determine the NPV for this project. Should Brower build the plant? b. How would your answer change if the value of the cedi was expected to remain unchanged from its current value of 8,700 cedi per U.S. dollar over the course of the 3 years? Should Brower construct the plant then?

14. Impact of Financing on NPV. Ventura Corp., a U.S.based MNC, plans to establish a subsidiary in Japan. It is very conﬁdent that the Japanese yen will appreciate against the dollar over time. The subsidiary will retain only enough revenue to cover expenses and will remit the rest to the parent each year. Will Ventura beneﬁt more from exchange rate effects if its parent provides equity ﬁ nancing for the subsidiary or if the subsidiary is ﬁ nanced by local banks in Japan? Explain. 15. Accounting for Changes in Risk. Santa Monica Co., a U.S.-based MNC, was considering establishing a consumer products division in Germany, which would be ﬁ nanced by German banks. Santa Monica completed its capital budgeting analysis in August. Then, in November, the government leadership

Chapter 14: Multinational Capital Budgeting

stabilized and political conditions improved in Germany. In response, Santa Monica increased its expected cash ﬂows by 20 percent but did not adjust the discount rate applied to the project. Should the discount rate be affected by the change in political conditions? 16. Estimating the NPV. Assume that a less developed country called LDC encourages direct foreign investment (DFI) in order to reduce its unemployment rate, currently at 15 percent. Also assume that several MNCs are likely to consider DFI in this country. The inﬂation rate in recent years has averaged 4 percent. The hourly wage in LDC for manufacturing work is the equivalent of about $5 per hour. When Piedmont Co. develops cash ﬂow forecasts to perform a capital budgeting analysis for a project in LDC, it assumes a wage rate of $5 in Year 1 and applies a 4 percent increase for each of the next 10 years. The components produced are to be exported to Piedmont’s headquarters in the United States, where they will be used in the production of computers. Do you think Piedmont will overestimate or underestimate the net present value of this project? Why? (Assume that LDC’s currency is tied to the dollar and will remain that way.) 17. PepsiCo’s Project in Brazil. PepsiCo recently decided to invest more than $300 million for expansion in Brazil. Brazil offers considerable potential because it has 150 million people and their demand for soft drinks is increasing. However, the soft drink consumption is still only about one-ﬁ fth of the soft drink consumption in the United States. PepsiCo’s initial outlay was used to purchase three production plants and a distribution network of almost 1,000 trucks to distribute its products to retail stores in Brazil. The expansion in Brazil was expected to make PepsiCo’s products more accessible to Brazilian consumers. a. Given that PepsiCo’s investment in Brazil was entirely in dollars, describe its exposure to exchange rate risk resulting from the project. Explain how the size of the parent’s initial investment and the exchange rate risk would have been affected if PepsiCo had ﬁ nanced much of the investment with loans from banks in Brazil. b. Describe the factors that PepsiCo likely considered when estimating the future cash ﬂows of the project in Brazil. c. What factors did PepsiCo likely consider in deriving its required rate of return on the project in Brazil? d. Describe the uncertainty that surrounds the estimate of future cash ﬂows from the perspective of the U.S. parent.

409

e. PepsiCo’s parent was responsible for assessing the

expansion in Brazil. Yet, PepsiCo already had some existing operations in Brazil. When capital budgeting analysis was used to determine the feasibility of this project, should the project have been assessed from a Brazilian perspective or a U.S. perspective? Explain. 18. Impact of Asian Crisis. Assume that Fordham Co. was evaluating a project in Thailand (to be ﬁ nanced with U.S. dollars). All cash ﬂows generated from the project were to be reinvested in Thailand for several years. Explain how the Asian crisis would have affected the expected cash ﬂows of this project and the required rate of return on this project. If the cash ﬂows were to be remitted to the U.S. parent, explain how the Asian crisis would have affected the expected cash ﬂows of this project. 19. Tax Effects on NPV. When considering the implementation of a project in one of various possible countries, what types of tax characteristics should be assessed among the countries? (See the chapter appendix.) 20. Capital Budgeting Analysis. A project in South Korea requires an initial investment of 2 billion South Korean won. The project is expected to generate net cash ﬂows to the subsidiary of 3 billion and 4 billion won in the 2 years of operation, respectively. The project has no salvage value. The current value of the won is 1,100 won per U.S. dollar, and the value of the won is expected to remain constant over the next 2 years. a. What is the NPV of this project if the required rate of return is 13 percent? b. Repeat the question, except assume that the value of the won is expected to be 1,200 won per U.S. dollar after 2 years. Further assume that the funds are blocked and that the parent company will only be able to remit them back to the United States in 2 years. How does this affect the NPV of the project? 21. Accounting for Exchange Rate Risk. Carson Co. is considering a 10-year project in Hong Kong, where the Hong Kong dollar is tied to the U.S. dollar. Carson Co. uses sensitivity analysis that allows for alternative exchange rate scenarios. Why would Carson use this approach rather than using the pegged exchange rate as its exchange rate forecast in every year? 22. Decisions Based on Capital Budgeting. Marathon, Inc., considers a one-year project with the Belgian government. Its euro revenue would be guaranteed. Its consultant states that the percentage change in the euro is represented by a normal distribution and that based on a 95 percent conﬁdence

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interval, the percentage change in the euro is expected to be between 0 and 6 percent. Marathon uses this information to create three scenarios: 0, 3, and 6 percent for the euro. It derives an estimated NPV based on each scenario and then determines the mean NPV. The NPV was positive for the 3 and 6 percent scenarios, but was slightly negative for the 0 percent scenario. This led Marathon to reject the project. Its manager stated that it did not want to pursue a project that had a one-in-three chance of having a negative NPV. Do you agree with the manager’s interpretation of the analysis? Explain. 23. Estimating Cash Flows of a Foreign Project. Assume that Nike decides to build a shoe factory in Brazil; half the initial outlay will be funded by the parent’s equity and half by borrowing funds in Brazil. Assume that Nike wants to assess the project from its own perspective to determine whether the project’s future cash ﬂows will provide a sufﬁcient return to the parent to warrant the initial investment. Why will the estimated cash ﬂows be different from the estimated cash ﬂows of Nike’s shoe factory in New Hampshire? Why will the initial outlay be different? Explain how Nike can conduct multinational capital budgeting in a manner that will achieve its objective. Advanced Questions 24. Break-even Salvage Value. A project in Malaysia costs $4 million. Over the next 3 years, the project will generate total operating cash ﬂows of $3.5 million, measured in today’s dollars using a required rate of return of 14 percent. What is the break-even salvage value of this project? 25. Capital Budgeting Analysis. Zistine Co. considers a one-year project in New Zealand so that it can capitalize on its technology. It is risk averse but is attracted to the project because of a government guarantee. The project will generate a guaranteed NZ$8 million in revenue, paid by the New Zealand government at the end of the year. The payment by the New Zealand government is also guaranteed by a credible U.S. bank. The cash ﬂows earned on the project will be converted to U.S. dollars and remitted to the parent in one year. The prevailing nominal one-year interest rate in New Zealand is 5 percent, while the nominal one-year interest rate in the United States is 9 percent. Zistine’s chief executive ofﬁcer believes that the movement in the New Zealand dollar is highly uncertain over the next year, but his best guess is that the change in its value will be in accordance with the international Fisher effect (IFE). He also believes that interest rate parity holds. He provides this information to three recent ﬁ nance graduates that he just hired as managers and asks them for their input.

a. The ﬁ rst manager states that due to the parity conditions, the feasibility of the project will be the same whether the cash ﬂows are hedged with a forward contract or are not hedged. Is this manager correct? Explain. b. The second manager states that the project should not be hedged. Based on the interest rates, the IFE suggests that Zistine Co. will beneﬁt from the future exchange rate movements, so the project will generate a higher NPV if Zistine does not hedge. Is this manager correct? Explain. c. The third manager states that the project should be hedged because the forward rate contains a premium and, therefore, the forward rate will generate more U.S. dollar cash ﬂows than the expected amount of dollar cash ﬂows if the ﬁ rm remains unhedged. Is this manager correct? Explain.

26. Accounting for Uncertain Cash Flows. Blustream, Inc., considers a project in which it will sell the use of its technology to ﬁ rms in Mexico. It already has received orders from Mexican ﬁ rms that will generate MXP3 million in revenue at the end of the next year. However, it might also receive a contract to provide this technology to the Mexican government. In this case, it will generate a total of MXP5 million at the end of the next year. It will not know whether it will receive the government order until the end of the year. Today’s spot rate of the peso is $.14. The oneyear forward rate is $.12. Blustream expects that the spot rate of the peso will be $.13 one year from now. The only initial outlay will be $300,000 to cover development expenses (regardless of whether the Mexican government purchases the technology). Blustream will pursue the project only if it can satisfy its required rate of return of 18 percent. Ignore possible tax effects. It decides to hedge the maximum amount of revenue that it will receive from the project. a. Determine the NPV if Blustream receives the government contract. b. If Blustream does not receive the contract, it will have hedged more than it needed to and will offset the excess forward sales by purchasing pesos in the spot market at the time the forward sale is executed. Determine the NPV of the project assuming that Blustream does not receive the government contract. c. Now consider an alternative strategy in which Blustream only hedges the minimum peso revenue that it will receive. In this case, any revenue due to the government contract would not be hedged. Determine the NPV based on this alternative strategy and assume that Blustream receives the government contract.

Chapter 14: Multinational Capital Budgeting d. If Blustream uses the alternative strategy of only hedging the minimum peso revenue that it will receive, determine the NPV assuming that it does not receive the government contract. e. If there is a 50 percent chance that Blustream

will receive the government contract, would you advise Blustream to hedge the maximum amount or the minimum amount of revenue that it may receive? Explain. f. Blustream recognizes that it is exposed to exchange rate risk whether it hedges the minimum amount or the maximum amount of revenue it will receive. It considers a new strategy of hedging the minimum amount it will receive with a forward contract and hedging the additional revenue it might receive with a put option on Mexican pesos. The one-year put option has an exercise price of $.125 and a premium of $.01. Determine the NPV if Blustream uses this strategy and receives the government contract. Also, determine the NPV if Blustream uses this strategy and does not receive the government contract. Given that there is a 50 percent probability that Blustream will receive the government contract, would you use this new strategy or the strategy that you selected in question (e)?

27. Capital Budgeting Analysis. Wolverine Corp. currently has no existing business in New Zealand but is considering establishing a subsidiary there. The following information has been gathered to assess this project: • The initial investment required is $50 million

in New Zealand dollars (NZ$). Given the existing spot rate of $.50 per New Zealand dollar, the initial investment in U.S. dollars is $25 million. In addition to the NZ$50 million initial investment for plant and equipment, NZ$20 million is needed for working capital and will be borrowed by the subsidiary from a New Zealand bank. The New Zealand subsidiary will pay interest only on the loan each year, at an interest rate of 14 percent. The loan principal is to be paid in 10 years. • The project will be terminated at the end of

Year 3, when the subsidiary will be sold. • The price, demand, and variable cost of the prod-

uct in New Zealand are as follows: Year

Price

Demand

Variable Cost

1

NZ$500

40,000 units

NZ$30

2

NZ$511

50,000 units

NZ$35

3

NZ$530

60,000 units

NZ$40

411

• The exchange rate of the New Zealand dollar is

expected to be $.52 at the end of Year 1, $.54 at the end of Year 2, and $.56 at the end of Year 3. • The New Zealand government will impose an in-

come tax of 30 percent on income. In addition, it will impose a withholding tax of 10 percent on earnings remitted by the subsidiary. The U.S. government will allow a tax credit on the remitted earnings and will not impose any additional taxes. • All cash ﬂows received by the subsidiary are to

be sent to the parent at the end of each year. The subsidiary will use its working capital to support ongoing operations. • The plant and equipment are depreciated over

10 years using the straight-line depreciation method. Since the plant and equipment are initially valued at NZ$50 million, the annual depreciation expense is NZ$5 million. • In 3 years, the subsidiary is to be sold. Wolverine

plans to let the acquiring ﬁ rm assume the existing New Zealand loan. The working capital will not be liquidated but will be used by the acquiring ﬁ rm that buys the subsidiary. Wolverine expects to receive NZ$52 million after subtracting capital gains taxes. Assume that this amount is not subject to a withholding tax. • Wolverine requires a 20 percent rate of return on

this project. a. Determine the net present value of this project.

Should Wolverine accept this project? b. Assume that Wolverine is also considering an al-

ternative ﬁ nancing arrangement, in which the parent would invest an additional $10 million to cover the working capital requirements so that the subsidiary would avoid the New Zealand loan. If this arrangement is used, the selling price of the subsidiary (after subtracting any capital gains taxes) is expected to be NZ$18 million higher. Is this alternative ﬁ nancing arrangement more feasible for the parent than the original proposal? Explain. c. From the parent’s perspective, would the NPV

of this project be more sensitive to exchange rate movements if the subsidiary uses New Zealand ﬁnancing to cover the working capital or if the parent invests more of its own funds to cover the working capital? Explain. d. Assume Wolverine used the original ﬁ nancing

proposal and that funds are blocked until the subsidiary is sold. The funds to be remitted are reinvested at a rate of 6 percent (after taxes) until the end of Year 3. How is the project’s NPV affected? e. What is the break-even salvage value of this proj-

• The ﬁ xed costs, such as overhead expenses, are

estimated to be NZ$6 million per year.

ect if Wolverine uses the original ﬁ nancing proposal and funds are not blocked?

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terest rate is 5 percent regardless of the maturity of the debt, and the annualized risk-free interest rate on euros is 7 percent, regardless of the maturity of the debt. Assume that interest rate parity exists. Cantoon’s cost of capital is 20 percent. It plans to use cash to make the acquisition.

f. Assume that Wolverine decides to implement the

project, using the original ﬁ nancing proposal. Also assume that after one year, a New Zealand ﬁ rm offers Wolverine a price of $27 million after taxes for the subsidiary and that Wolverine’s original forecasts for Years 2 and 3 have not changed. Compare the present value of the expected cash ﬂows if Wolverine keeps the subsidiary to the selling price. Should Wolverine divest the subsidiary? Explain. 28. Capital Budgeting with Hedging. Baxter Co. considers a project with Thailand’s government. If it accepts the project, it will deﬁ nitely receive one lumpsum cash ﬂow of 10 million Thai baht in 5 years. The spot rate of the Thai baht is presently $.03. The annualized interest rate for a 5-year period is 4 percent in the United States and 17 percent in Thailand. Interest rate parity exists. Baxter plans to hedge its cash ﬂows with a forward contract. What is the dollar amount of cash ﬂows that Baxter will receive in 5 years if it accepts this project? 29. Capital Budgeting and Financing. Cantoon Co. is considering the acquisition of a unit from the French government. Its initial outlay would be $4 million. It will reinvest all the earnings in the unit. It expects that at the end of 8 years, it will sell the unit for 12 million euros after capital gains taxes are paid. The spot rate of the euro is $1.20 and is used as the forecast of the euro in the future years. Cantoon has no plans to hedge its exposure to exchange rate risk. The annualized U.S. risk-free in-

BLADES,

INC.

a. Determine the NPV under these conditions. b. Rather than use all cash, Cantoon could partially ﬁ nance the acquisition. It could obtain a loan of 3 million euros today that would be used to cover a portion of the acquisition. In this case, it would have to pay a lump-sum total of 7 million euros at the end of 8 years to repay the loan. There are no interest payments on this debt. The way in which this ﬁ nancing deal is structured, none of the payment is tax deductible. Determine the NPV if Cantoon uses the forward rate instead of the spot rate to forecast the future spot rate of the euro, and elects to partially ﬁ nance the acquisition. You need to derive the 8-year forward rate for this speciﬁc question.

Discussion in the Boardroom This exercise can be found in Appendix E at the back of this textbook. Running Your Own MNC This exercise can be found on the Xtra! website at http://maduraxtra.swlearning.com.

CASE

Decision by Blades, Inc., to Invest in Thailand Since Ben Holt, Blades’ chief ﬁ nancial ofﬁcer (CFO), believes the growth potential for the roller blade market in Thailand is very high, he, together with Blades’ board of directors, has decided to invest in Thailand. The investment would involve establishing a subsidiary in Bangkok consisting of a manufacturing plant to produce “Speedos,” Blades’ high-quality roller blades. Holt believes that economic conditions in Thailand will be relatively strong in 10 years, when he expects to sell the subsidiary. Blades will continue exporting to the United Kingdom under an existing agreement with Jogs, Ltd., a British retailer. Furthermore, it will continue its sales in the United States. Under an existing agreement with Entertainment Products, Inc., a Thai retailer, Blades is committed to selling 180,000 pairs of Speedos to

the retailer at a ﬁ xed price of 4,594 Thai baht per pair. Once operations in Thailand commence, the agreement will last another year, at which time it may be renewed. Thus, during its ﬁ rst year of operations in Thailand, Blades will sell 180,000 pairs of roller blades to Entertainment Products under the existing agreement whether it has operations in the country or not. If it establishes the plant in Thailand, Blades will produce 108,000 of the 180,000 Entertainment Products Speedos at the plant during the last year of the agreement. Therefore, the new subsidiary would need to import 72,000 pairs of Speedos from the United States so that it can accommodate its agreement with Entertainment Products. It will save the equivalent of 300 baht per pair in varible costs on the 108,000 pairs not previously manufactured in Thailand.

Chapter 14: Multinational Capital Budgeting

Entertainment Products has already declared its willingness to renew the agreement for another 3 years under identical terms. Because of recent delivery delays, however, it is willing to renew the agreement only if Blades has operations in Thailand. Moreover, if Blades has a subsidiary in Thailand, Entertainment Products will keep renewing the existing agreement as long as Blades operates in Thailand. If the agreement is renewed, Blades expects to sell a total of 300,000 pairs of Speedos annually during its ﬁ rst 2 years of operation in Thailand to various retailers, including 180,000 pairs to Entertainment Products. After this time, it expects to sell 400,000 pairs annually (including 180,000 to Entertainment Products). If the agreement is not renewed, Blades will be able to sell only 5,000 pairs to Entertainment Products annually, but not at a ﬁ xed price. Thus, if the agreement is not renewed, Blades expects to sell a total of 125,000 pairs of Speedos annually during its ﬁ rst 2 years of operation in Thailand and 225,000 pairs annually thereafter. Pairs not sold under the contractual agreement with Entertainment Products will be sold for 5,000 Thai baht per pair, since Entertainment Products had required a lower price to compensate it for the risk of being unable to sell the pairs it purchased from Blades. Ben Holt wishes to analyze the ﬁ nancial feasibility of establishing a subsidiary in Thailand. As a Blades’ ﬁ nancial analyst, you have been given the task of analyzing the proposed project. Since future economic conditions in Thailand are highly uncertain, Holt has also asked you to conduct some sensitivity analyses. Fortunately, he has provided most of the information you need to conduct a capital budgeting analysis. This information is detailed here: • The building and equipment needed will cost 550 million Thai baht. This amount includes additional funds to support working capital. • The plant and equipment, valued at 300 million baht, will be depreciated using straight-line depreciation. Thus, 30 million baht will be depreciated annually for 10 years. • The variable costs needed to manufacture Speedos are estimated to be 3,500 baht per pair next year. • Blades’ ﬁ xed operating expenses, such as administrative salaries, will be 25 million baht next year. • The current spot exchange rate of the Thai baht is $.023. Blades expects the baht to depreciate by an average of 2 percent per year for the next 10 years. • The Thai government will impose a 25 percent tax rate on income and a 10 percent withholding tax

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on any funds remitted by the subsidiary to Blades. Any earnings remitted to the United States will not be taxed again. • After 10 years, Blades expects to sell its Thai subsidiary. It expects to sell the subsidiary for about 650 million baht, after considering any capital gains taxes. • The average annual inﬂation in Thailand is expected to be 12 percent. Unless prices are contractually ﬁ xed, revenue, variable costs, and ﬁ xed costs are subject to inﬂation and are expected to change by the same annual rate as the inﬂation rate. Blades could continue its current operations of exporting to and importing from Thailand, which have generated a return of about 20 percent. Blades requires a return of 25 percent on this project in order to justify its investment in Thailand. All excess funds generated by the Thai subsidiary will be remitted to Blades and will be used to support U.S. operations. Ben Holt has asked you to answer the following questions: 1. Should the sales and the associated costs of 180,000 pairs of roller blades to be sold in Thailand under the existing agreement be included in the capital budgeting analysis to decide whether Blades should establish a subsidiary in Thailand? Should the sales resulting from a renewed agreement be included? Why or why not? 2. Using a spreadsheet, conduct a capital budgeting analysis for the proposed project, assuming that Blades renews the agreement with Entertainment Products. Should Blades establish a subsidiary in Thailand under these conditions? 3. Using a spreadsheet, conduct a capital budgeting analysis for the proposed project assuming that Blades does not renew the agreement with Entertainment Products. Should Blades establish a subsidiary in Thailand under these conditions? Should Blades renew the agreement with Entertainment Products? 4. Since future economic conditions in Thailand are uncertain, Ben Holt would like to know how critical the salvage value is in the alternative you think is most feasible. 5. The future value of the baht is highly uncertain. Under a worst-case scenario, the baht may depreciate by as much as 5 percent annually. Revise your spreadsheet to illustrate how this would affect Blades’ decision to establish a subsidiary in Thailand. (Use the capital budgeting analysis you have identiﬁed as the most favorable from questions 2 and 3 to answer this question.)

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SMALL

BUSINESS

DILEMMA

Multinational Capital Budgeting by the Sports Exports Company Jim Logan, owner of the Sports Exports Company, has been pleased with his success in the United Kingdom. He began his business by producing footballs and exporting them to the United Kingdom. While American-style football is still not nearly as popular in the United Kingdom as it is in the United States, his ﬁ rm controls the market in the United Kingdom. Jim is considering an application of the same business in Mexico. He would produce the footballs in the United States and export them to a distributor of sporting goods in Mexico, who would sell the footballs to retail

I N T E R N E T/ E XC E L Assume that you invested equity to establish a project in Portugal in January of about 7 years ago. At the time the project began, you could have supported it with a 7-year loan either in dollars or in euros. If you borrowed U.S. dollars, your annual loan payment (including principal) would have been $2.5 million. If you borrowed euros, your annual loan payment (including principal) would have been 2 million euros. The project generated 5 million euros per year in revenue. 1. Use an Excel spreadsheet to determine the dollar net cash ﬂows (after making the debt payment) that you would receive at the end of each of the last 7 years if you partially ﬁ nanced the project by borrowing dollars.

stores. The distributor likely would want to pay for the product each month in Mexican pesos. Jim would need to hire one full-time employee in the United States to produce the footballs. He would also need to lease one warehouse. 1. Describe the capital budgeting steps that would be necessary to determine whether this proposed project is feasible, as related to this speciﬁc situation. 2. Explain why there is uncertainty surrounding the cash ﬂows of this project.

EXERCISES 2. Determine the standard deviation of the dollar net cash ﬂows that you would receive at the end of each of the last 7 years if you partially ﬁ nanced the project by borrowing dollars. 3. Reestimate the dollar net cash ﬂows and the standard deviation of the dollar net cash ﬂows if you partially ﬁ nanced the project by borrowing euros. (You can obtain the end-of-year exchange rate of the euro for the last 7 years at http://www.oanda. com or other websites.) Are the project’s net cash ﬂows more volatile if you had borrowed dollars or euros? Explain your results.

APPENDIX 14 Incorporating International Tax Laws in Multinational Capital Budgeting

Tax laws can vary among countries in many ways, but any type of tax causes an MNC’s after-tax cash ﬂows to differ from its before-tax cash ﬂows. To estimate the future cash ﬂows that are to be generated by a proposed foreign project (such as the establishment of a new subsidiary or the acquisition of a foreign ﬁ rm), MNCs must ﬁ rst estimate the taxes that they will incur due to the foreign project. This appendix provides a general background on some of the more important international tax characteristics that an MNC must consider when assessing foreign projects. Financial managers do not necessarily have to be international tax experts because they may be able to rely on the MNC’s international tax department or on independent tax consultants for guidance. Nevertheless, they should at least be aware of international tax characteristics that can affect the cash ﬂows of a foreign project and recognize how those characteristics can vary among the countries where foreign projects are considered.

Variation in Tax Laws among Countries Each country generates tax revenue in different ways. The United States relies on corporate and individual income taxes for federal revenue. Other countries may depend more on a value-added tax (VAT) or excise taxes. Since each country has its own philosophy on whom to tax and how much, it is not surprising that the tax treatment of corporations differs among countries. Because each country has a unique tax system and tax rates, MNCs need to recognize the various tax provisions of each country where they consider investing in a foreign project. The more important tax characteristics of a country to be considered in an MNC’s international tax assessment are (1) corporate income taxes, (2) withholding taxes, (3) personal and excise tax rates, (4) provision for carrybacks and carryforwards, (5) tax treaties, (6) tax credits, and (7) taxes on income from intercompany transactions. A discussion of each characteristic follows.

Corporate Income Taxes In general, countries impose taxes on corporate income generated within their borders, even if the parents of those corporations are based in other countries. Each country has its unique corporate income tax laws. The United States, for example, taxes the worldwide income of U.S. persons, a term that includes corporations. As a general rule, however, foreign income of a foreign subsidiary of a U.S. company is not taxed until it is transferred to the U.S. parent by payment of dividends or a liquidation distribution. This is the concept of deferral. An MNC planning direct foreign investment in foreign countries must determine how the anticipated earnings from a foreign project will be affected. Tax rates

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H T T P : // http://www.pwcglobal.com Access to country-speciﬁc information such as general business rules and regulations and tax environments.

imposed on income earned by businesses (including foreign subsidiaries of MNCs) or income remitted to a parent are shown in Exhibit 14A.1 for several countries. The tax rates may be lower than what is shown for corporations that have relatively low levels of earnings. This exhibit shows the extent to which corporate income tax rates can vary among host countries and illustrates why MNCs closely assess the tax guidelines in any foreign country where they consider conducting direct foreign investment. Given differences in tax deductions, depreciation, business subsidies, and other factors, corporate tax differentials cannot be measured simply by comparing quoted tax rates across countries. Corporate tax rates can also differ within a country, depending on whether the entity is a domestic corporation. Also, if an unregistered foreign corporation is considered to have a permanent establishment in a country, it may be subject to that country’s tax laws on income earned within its borders. Generally, a permanent establishment includes an ofﬁce or ﬁ xed place of business or a speciﬁed kind of agency (independent agents are normally excluded) through which active and continuous business is conducted. In some cases, the tax depends on the industry or on the form of business used (e.g., corporation, branch, partnership).

Withholding Taxes The following types of payments by an MNC’s subsidiary are commonly subject to a withholding tax by the host government: (1) A subsidiary may remit a portion of its earnings, referred to as dividends, to its parent since the parent is the shareholder of the subsidiary. (2) The subsidiary may pay interest to the parent or to other nonExhibit 14A.1 Country

Comparison of Tax Characteristics among Countries Corporate Income Tax

Country

Corporate Income Tax

Argentina

35%

Israel

36

Australia

30

Italy

37

Austria

34

Japan

42

Belgium

34

Korea

30

Brazil

34

Malaysia

28

Canada

36

Mexico

33

Chile

17

Netherlands

35

China

33

New Zealand

33

Czech Republic

28

Singapore

22

France

34

Spain

35

Germany

38

Switzerland

24

Hong Kong

17

Taiwan

25

Hungary

16

United Kingdom

30

India

36

United States

35

Indonesia

30

Venezuela

34

Ireland

13

Source: Worldwide Corporate Tax Guide, Ernst & Young. The numbers provided are for illustrative purposes only, as the actual tax rate may depend on specific characteristics of the MNC.

Chapter 14: Multinational Capital Budgeting

http://ﬁnance.yahoo.com/ Information about taxes imposed by each country.

resident debtholders from which it received loans. (3) The subsidiary may make payments to the parent or to other nonresident ﬁ rms in return for the use of patents (such as technology) or other rights. The payment of dividends reduces the amount of reinvestment by the subsidiary in the host country. The payments by the subsidiary to nonresident ﬁ rms to cover interest or patents reﬂect expenses by the subsidiary, which will normally reduce its taxable income and therefore will reduce the corporate income taxes paid to the host government. Thus, withholding taxes may be a way for host governments to tax MNCs that make interest or patent payments to nonresident ﬁ rms. Since withholding taxes imposed on the subsidiary can reduce the funds remitted by the subsidiary to the parent, the withholding taxes must be accounted for in a capital budgeting analysis conducted by the parent. As with corporate tax rates, the withholding tax rate can vary substantially among countries.

Reducing Exposure to Withholding Taxes. Withholding taxes can be reduced by income tax treaties (discussed shortly). Because of tax treaties between some countries, the withholding taxes may be lower when the MNC’s parent is based in a county participating in the treaties. If the host country government of a particular subsidiary imposes a high withholding tax on subsidiary earnings remitted to the parent, the parent of the MNC may instruct the subsidiary to temporarily refrain from remitting earnings and to reinvest them in the host country instead. As an alternative approach, the MNC may instruct the subsidiary to set up a research and development division that will enhance subsidiaries elsewhere. The main purpose behind this strategy is to efﬁciently use the funds abroad when the funds cannot be sent to the parent without excessive taxation. Since international tax laws can inﬂuence the timing of the transfer of funds to the parent, they affect the timing of cash ﬂows on proposed foreign projects. Therefore, the international tax implications must be understood before the cash ﬂows of a foreign project can be estimated.

Personal and Excise Tax Rates An MNC is more likely to be concerned with corporate tax rates and withholding tax rates than individual tax rates because its cash ﬂows are directly affected by the taxes incurred. However, a country’s individual tax rates can indirectly affect an MNC’s cash ﬂows because the MNC may have to pay higher wages to employees in countries (such as in Europe) where personal income is taxed at a relatively high rate. In addition, a country’s value-added tax or excise tax may affect cash ﬂows to be generated from a foreign project because it may make the products less competitive on a global basis (reducing the expected quantity of products to be sold).

Provision for Carrybacks and Carryforwards Negative earnings from operations can often be carried back or forward to offset earnings in other years. The laws pertaining to these so-called net operating loss carrybacks and carryforwards can vary among countries. An MNC generally does not plan to generate negative earnings in foreign countries. If negative earnings do occur, however, it is desirable to be able to use them to offset other years of positive earnings. Most foreign countries do not allow negative earnings to be carried back but allow some ﬂexibility in carrying losses forward. Since many foreign projects are expected to result in negative earnings in the early years, the tax laws for the country of concern will affect the future tax deductions resulting from these losses and will therefore affect the future cash ﬂows of the foreign project.

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Tax Treaties Countries often establish income tax treaties, whereby one partner will reduce its taxes by granting a credit for taxes imposed on corporations operating within the other treaty partner’s tax jurisdiction. Income tax treaties help corporations avoid exposure to double taxation. Some treaties apply to taxes paid on income earned by MNCs in foreign countries. Other treaties apply to withholding taxes imposed by the host country on foreign earnings that are remitted to the parent. Without such treaties, subsidiary earnings could be taxed by the host country and then again by the parent’s country when received by the parent. To the extent that the parent uses some of these earnings to provide cash dividends for shareholders, triple taxation could result (since the dividend income is also taxed at the shareholder level). Because income tax treaties reduce taxes on earnings generated by MNCs, they help stimulate direct foreign investment. Many foreign projects that are perceived as feasible would not be feasible without income tax treaties because the expected cash ﬂows would be reduced by excessive taxation.

Tax Credits Even without income tax treaties, an MNC may be allowed a credit for income and withholding taxes paid in one country against taxes owed by the parent if it meets certain requirements. Like income tax treaties, tax credits help to avoid double taxation and stimulate direct foreign investment. Tax credit policies vary somewhat among countries, but they generally work like this. Consider a U.S.-based MNC subject to a U.S. tax rate of 35 percent. Assume that a foreign subsidiary of this corporation has generated earnings taxed at less than 35 percent by the host country’s government. The earnings remitted to the parent from the subsidiary will be subject to an additional amount of U.S. tax to bring the total tax up to 35 percent. From the parent’s point of view, the tax on its subsidiary’s remitted earnings are 35 percent overall, so it does not matter whether the host country of the subsidiary or the United States receives most of the taxes. From the perspective of the governments of these two countries, however, the allocation of taxes is very important. If subsidiaries of U.S. corporations are established in foreign countries, and if these countries tax income at a rate close to 35 percent, they can generate large tax revenues from income earned by the subsidiaries. The host countries receive the tax revenues at the expense of the parent’s country (the United States, in this case). If the corporate income tax rate in a foreign country is greater than 35 percent, the United States generally does not impose any additional taxes on earnings remitted to a U.S. parent by foreign subsidiaries in that country. In fact, under current law, the United States allows the excess foreign tax to be credited against other taxes owed by the parent, due on the same type of income generated by subsidiaries in other lower-tax countries. In a sense, this suggests that some host countries could charge abnormally high corporate income tax rates to foreign subsidiaries and still attract direct foreign investment. If the MNC in our example has subsidiaries located in some countries with low corporate income taxes, the U.S. tax on earnings remitted to the U.S. parent will normally bring the total tax up to 35 percent. Yet, credits against excessive income taxes by high-tax countries on foreign subsidiaries could offset these taxes that would otherwise be paid to the U.S. government. Due to tax credits, therefore, an MNC might be more willing to invest in a project in a country with excessive tax rates. Basic information on a country’s current taxes may not be sufﬁcient for determining the tax effects of a particular foreign project because tax incentives may be offered in particular circumstances, and tax rates can change over time. Consider an MNC that plans to establish a manufacturing plant in Country Y rather than Coun-

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Taxes on Income from Intercompany Transactions Many of an MNC’s proposed foreign projects will involve intercompany transactions. For example, a U.S-based MNC may consider acquiring a foreign ﬁ rm that will produce and deliver supplies to its U.S. subsidiaries. Under these conditions, the MNC must use transfer pricing, which involves pricing the transactions between two entities (such as subsidiaries) of the same corporation. When MNCs consider new foreign projects, they must incorporate their transfer pricing to properly estimate cash ﬂ ows that will be generated from these projects. Therefore, before the feasibility of a foreign project can be determined, transfer pricing decisions must be made on any anticipated intercompany transactions that would result from the new project. MNCs are subject to some guidelines on transfer pricing, but they usually have some ﬂexibility and tend to use a transfer pricing policy that will minimize taxes while satisfying the guidelines. Oakland Corp. has established two subsidiaries to capitalize on low production costs. One of these subsidiaries (called Hitax Sub) is located in a country whose government imposes a 50 percent tax rate on before-tax earnings. Hitax Sub produces partially finished products and sends them to the other subsidiary (called Lotax Sub) where the final assembly takes place. The host government of Lotax Sub imposes a 20 percent tax on before-tax earnings. To simplify the example, assume that no dividends are to be remitted to the parent in the near future. Given this information, pro forma income statements would be as shown in the top part of Exhibit 14A.2 for Hitax Sub (second column), Lotax Sub (third column), and the combined subsidiaries (last column). The income statement items are reported in U.S. dollars to more easily illustrate how a revised transfer pricing policy can affect earnings and cash flows. The sales level shown for Hitax Sub matches the cost of goods sold for Lotax Sub, indicating that all Hitax Sub sales are to Lotax Sub. The additional expenses incurred by Lotax Sub to complete the product are classified as operating expenses. Notice from Exhibit 14A.2 that both subsidiaries have the same earnings before taxes. Yet, because of the different tax rates, Hitax Sub’s after-tax income is $7.5 million less than Lotax Sub’s. If Oakland Corp. can revise its transfer pricing, its combined earnings after taxes will be increased. To illustrate, suppose that the price of products sent from Hitax Sub to Lotax

E X A M P L E

APPENDIX 14

try X. Assume that while many economic characteristics favor Country X, the current tax rates in Country Y are lower. However, whereas tax rates in Country X have been historically stable and are expected to continue that way, they have been changing every few years in Country Y. In this case, the MNC must assess the future uncertainty of the tax rates. It cannot treat the current tax rate of Country Y as a constant when conducting a capital budgeting analysis. Instead, it must consider possible changes in the tax rates over time and, based on these possibilities, determine whether Country Y’s projected tax advantages over time sufﬁciently outweigh the advantages of Country X. One approach to account for possible changes in the tax rates is to use sensitivity analysis, which measures the sensitivity of the net present value (NPV ) of after-tax cash ﬂows to various possible tax changes over time. For each tax scenario, a different NPV is projected. By accounting for each possible tax scenario, the MNC can develop a distribution of possible NPVs that may occur and can then compare these for each country. Two critical, broadly deﬁ ned functions are necessary to determine how international tax laws affect the cash ﬂows of a foreign project. The ﬁ rst is to be aware of all the current (and possible future) tax laws that exist for each country where the MNC does (or plans to do) business. The second is to take the information generated from the ﬁ rst function and apply it to forecasted earnings and remittances to determine the taxes, so that the proposed project’s cash ﬂows can be estimated.

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Exhibit 14A.2

Impact of Transfer Pricing Adjustment on Pro Forma Earnings and Taxes: Oakland Corp. (in Thousands) Original Estimates Hitax Sub

Lotax Sub

Combined1

$100,000

$150,000

$250,000

Less: Cost of goods sold

50,000

100,000

150,000

Gross proﬁt

50,000

50,000

100,000

Less: Operating expenses

20,000

20,000

40,000

Earnings before interest and taxes

30,000

30,000

60,000

5,000

5,000

10,000

Earnings before taxes

25,000

25,000

50,000

Taxes (50% for Hitax and 20% for Lotax)

12,500

5,000

17,500

$12,500

$20,000

$32,500

Sales

Interest expense

Earnings after taxes

Revised Estimates Based on Adjusting Transfer Pricing Policy Hitax Sub

Lotax Sub

Combined1

$80,000

$150,000

$230,000

Less: Cost of goods sold

50,000

80,000

130,000

Gross proﬁt

30,000

70,000

100,000

Less: Operating expenses

20,000

20,000

40,000

Earnings before interest and taxes

10,000

50,000

60,000

Interest expense

5,000

5,000

10,000

Earnings before taxes

5,000

45,000

50,000

Taxes (50% for Hitax and 20% for Lotax)

2,500

9,000

11,500

$2,500

$36,000

$38,500

Sales

Earnings after taxes 1

The combined numbers are shown here for illustrative purposes only and do not reﬂect the ﬁrm’s ofﬁcial consolidated ﬁnancial statements. When consolidating sales for ﬁnancial statements, intercompany transactions (between subsidiaries) would be eliminated. This example is intended simply to illustrate how total taxes paid by subsidiaries are lower when transfer pricing is structured to shift some gross proﬁt from a high-tax subsidiary to a low-tax subsidiary.

Sub is reduced, causing Hitax Sub’s sales to decline from $100 million to $80 million. This also reduces Lotax Sub’s cost of goods sold by $20 million. The revised pro forma income statement resulting from the change in the transfer pricing policy is shown in the bottom part of Exhibit 14A.2. The two subsidiaries’ forecasted earnings before taxes now differ by $40 million, although the combined amount has not changed. Because earnings have been shifted from Hitax Sub to Lotax Sub, the total tax payments are reduced to $11.5 million from the original estimate of $17.5 million. Thus, the corporate taxes imposed on earnings are now forecasted to be $6 million lower than originally expected. ■

It should be mentioned that possible adjustments in the transfer pricing policies may be limited because host governments may restrict such practices when the intent is to avoid taxes. Transactions between subsidiaries of a ﬁ rm are supposed to be priced using the principle of “arm’s-length” transactions. That is, the price should be set as if the buyer is unrelated to the seller and should not be adjusted simply to shift tax burdens. Nevertheless, there is some ﬂexibility on transfer pricing policies, enabling

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421 APPENDIX 14

MNCs from all countries to attempt to establish policies that are within legal limits, but also reduce tax burdens. Even if the transfer price reﬂects the “fair” price that would normally be charged in the market, one subsidiary can still charge another for technology transfers, research and development expenses, or other forms of overhead expenses incurred. The actual mechanics of international transfer pricing go far beyond the example provided here. The U.S. laws in this area are particularly strict. Nevertheless, there are various ways that MNCs can justify increasing prices at one subsidiary and reducing them at another. There is substantial evidence that MNCs based in numerous countries use transfer pricing strategies to reduce their taxes. Moreover, transfer pricing restrictions can be circumvented in several ways. Various fees can be implemented for services, research and development, royalties, and administrative duties. Although the fees may be imposed to shift earnings and minimize taxes, they have the effect of distorting the actual performance of each subsidiary. To correct for any distortion, the MNC can use a centralized approach to account for the transfer pricing strategy when assessing the performance of each subsidiary.

15: International Acquisitions Multinational corporations (MNCs) commonly engage in international acquisitions as a means of penetrating a foreign market or capitalizing on lower costs of production. International acquisitions involve the identiﬁcation of possible foreign targets, valuation of targets, negotiating the deal, and revising the organizational structure. The specific objectives of this chapter are to:

■ explain how MNCs conduct valuations of foreign

target firms, ■ explain why valuations of a target firm vary among

MNCs that plan to restructure by acquiring a target, and ■ identify other types of multinational restructuring be-

sides international acquisitions.

■ provide a background on how MNCs use international

acquisitions as a form of multinational restructuring,

Background on International Acquisitions An international acquisition of a ﬁ rm is similar to other international projects in that it requires an initial outlay and is expected to generate cash ﬂows whose present value will exceed the initial outlay. Many international acquisitions are motivated by the desire to increase global market share or to capitalize on economies of scale through global consolidation. U.S.-based MNCs such as Oracle Corporation, Ford Motor Co., Google, Inc., Borden, Inc., and Dow Chemical Co. have recently engaged in international acquisitions. MNCs may view international acquisitions as a better form of direct foreign investment (DFI) than establishing a new subsidiary. However, there are distinct differences between these two forms of DFI. Through an international acquisition, the ﬁ rm can immediately expand its international business since the target is already in place. Establishing a new subsidiary requires time. Yahoo! had successfully established portals in Europe and Asia. However, it believed that it could improve its presence in Asia by focusing on the Greater China area. China has much potential because of its population base, but it also imposes restrictions that discourage DFI by firms. Meanwhile, Kimo, a privately held company and the leading portal in Taiwan, had 4 million registered users in Taiwan. Yahoo! agreed to acquire Kimo for about $150 million. With this DFI, Yahoo! not only established a presence in Taiwan, but also established a link to mainland China. ■

E X A M P L E

When viewed as a project, the international acquisition usually generates quicker and larger cash ﬂows than the establishment of a new subsidiary, but it also requires a larger initial outlay. International acquisitions also necessitate the integration of the parent’s management style with that of the foreign target. 422

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423

Trends in International Acquisitions The volume of foreign acquisitions of U.S. ﬁ rms has increased consistently since 1993. In particular, European ﬁ rms have been attractive targets for U.S. ﬁ rms attempting to establish a presence in Europe due to the more uniform regulations across countries in the European Union, the momentum for free enterprise in Eastern Europe, and the inception of the euro. U.S. ﬁ rms acquire more targets in the United Kingdom than in any other country. British and Canadian ﬁ rms are the most common nonU.S. acquirers of U.S. targets.

H T T P : // http://www.cia.gov Provides a link to the World Factbook, which has valuable information about countries that would be considered by MNCs that may attempt to acquire foreign targets.

Model for Valuing a Foreign Target Recall from Chapter 1 that the value of an MNC is based on the present value of expected cash ﬂows to be received. When an MNC engages in restructuring, it affects the structure of its assets, which will ultimately affect the present value of its cash ﬂows. For example, if it acquires a company, it will incur a large initial outlay this year, but its expected annual cash ﬂows will now be larger. An MNC’s decision to invest in a foreign company is similar to the decision to invest in other projects in that it is based on a comparison of beneﬁts and costs as measured by net present value. From an MNC’s parent’s perspective, the foreign target’s value can be estimated as the present value of cash ﬂows that it would receive from the target, as the target would become a foreign subsidiary owned by the parent. The MNC’s parent would consider investing in the target only if the estimated present value of the cash ﬂows it would ultimately receive from the target over time exceeds the initial outlay necessary to purchase the target. Thus, capital budgeting analysis can be used to determine whether a ﬁ rm should be acquired. The net present value of a company from the acquiring ﬁ rm’s perspective (NPVa) is n CFa,t SVa NPVa 5 2IOa 1 a t 1 1 2 1 1 1 k 1 1 k2n t51

where IOa initial outlay needed by the acquiring ﬁ rm to acquire the target CFa,t cash ﬂow to be generated by the target for the acquiring ﬁ rm k required rate of return on the acquisition of the target SVa salvage value of the target (expected selling price of the target at a point in the future) n time when the target will be sold by the acquiring ﬁ rm

Estimating the Initial Outlay. The initial outlay reﬂects the price to be paid for the target. When ﬁ rms acquire publicly traded foreign targets, they commonly pay premiums of between 10 and 40 percent above the prevailing stock price of the target in order to gain ownership. This type of premium is also typical for acquisitions of domestic targets. The main point here is that the estimate of the initial outlay must account for the premium since an MNC normally will not be able to purchase a publicly traded target at the target’s prevailing market value. For an acquisition to be successful, it means that the acquirer must substantially improve the target’s cash ﬂows so that it can overcome the large premium it pays for the target. Some international acquisitions backﬁ re because the MNC overestimates the net cash ﬂows of the target. That is, the MNC’s managers are excessively optimistic when estimating the target’s future cash ﬂows, which leads them to make acquisitions that are not feasible. The capital budgeting analysis of a foreign target must also account for the exchange rate of concern. For example, consider a U.S.-based MNC that assesses the acquisition of a foreign company. The dollar initial outlay (IOU.S.) needed by the U.S.

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ﬁ rm is determined by the acquisition price in foreign currency units (IOf) and the spot rate of the foreign currency (S): IOU.S. 5 IOf 1 S 2

Estimating the Cash Flows. The dollar amount of cash ﬂows to the U.S. ﬁ rm is determined by the foreign currency cash ﬂows (CFf,t) per period remitted to the United States and the spot rate at that time (St): CFa,t 5 (CFf,t)St This ignores any withholding taxes or blocked-funds restrictions imposed by the host government and any income taxes imposed by the U.S. government. The dollar amount of salvage value to the U.S. ﬁ rm is determined by the salvage value in foreign currency units (SVf) and the spot rate at the time (period n) when it is converted to dollars (Sn): SVa 5 1 SVf 2 Sn

Estimating the NPV. The net present value of a foreign target can be derived by substituting the equalities just described in the capital budgeting equation: n CFa,t SVa NPVa 5 2IOa 1 a t 1 1 2 1 1 1 k2n t51 1 1 k

n 1 CF 2 S 1 SVf 2 Sn f,t t 5 2 1 IOf 2 S 1 a t 1 11 1 k2n t51 1 1 1 k 2

Market Assessment of International Acquisitions

H T T P : // http://www.worldbank.org Data on socioeconomic development and performance indicators as well as links to statistical and projectoriented publications and analyses.

In general, announcements of acquisitions of foreign targets lead to neutral or slightly favorable stock price effects for acquirers, on average, whereas acquisitions of domestic targets lead to negative effects for acquirers, on average. The more favorable results for foreign targets are possibly attributed to the ability of acquirers to more easily capitalize on their strengths in foreign markets. For example, they may have a comparative advantage in terms of their technology or image in a foreign market where competition is not as intense as in their domestic market. The publicly traded targets almost always experience a large favorable stock price response at the time of the acquisition, which is attributed to the large premium that the acquirer is willing to pay for the target. Once international acquisitions are approved by the regulators, the MNC can acquire the target’s shares.

Assessing Potential Acquisitions after the Asian Crisis Although the Asian crisis had devastating effects, it created an opportunity for some MNCs to pursue new business in Asia. The initial outlay for acquiring a ﬁ rm in Asia was lower as a result of the crisis. First, property values in Asia had declined. Second, the parent’s currency (for parents in the United States or Europe) had more purchasing power due to the weakening of the Asian currencies. Third, many ﬁ rms in Asia were near bankruptcy and were unable to obtain necessary funding. Fourth, the governments in these countries were more willing to allow foreign acquisitions of local ﬁ rms (especially those that were failing) as a means of resolving the crisis. Consequently, some U.S. and European ﬁ rms pursued direct foreign investment in Asia during the Asian crisis. In the first 6 months of 1998, U.S. firms invested more than $8 billion in Asia—more than double the amount they had invested there in all of 1997. Procter & Gamble agreed to acquire Sanyong Paper (a large conglomerate in South Korea) during the crisis. Citicorp obtained a large stake in First City Bank in Thailand. ■

E X A M P L E

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Firms that made acquisitions had to consider the obvious adverse effects of the crisis in their capital budgeting analysis. The lower economic growth meant that most Asian projects would generate lower cash ﬂows, and the weak currencies reduced the amount of cash ﬂows (in the parent’s currency) that would ultimately be received as a return on the parent’s investment. To the extent that the ﬁ rms believed that the Asian currency values had hit bottom and would rebound, they could assume that any new acquisitions of Asian ﬁ rms would beneﬁt from future exchange rate movements. Firms could initiate their investment in Asia by investing their home currency in exchange for the weak Asian currency. Then, if the Asian currency appreciated over time, the earnings generated there would be worth more (in terms of the parent’s currency) when remitted to the parent.

Assessing Potential Acquisitions in Europe Before the adoption of the euro, a U.S.-based MNC had to separately consider the exchange rate effects from acquiring ﬁ rms in different European countries. For example, Italy’s currency (the lira) was considered more likely to weaken against the dollar than some of the other European currencies, and this could affect the decision of whether to acquire an Italian ﬁ rm versus a ﬁ rm in Germany or France. The adoption of the euro as the local currency by several European countries has simpliﬁed the analysis for an MNC that is comparing possible target ﬁ rms in those countries. The U.S.-based MNC can still be affected by future movements in the euro’s value against the dollar, but those effects will occur regardless of whether the MNC purchases a ﬁ rm in Italy or in any other euro zone country. Thus, the MNC can make its decision on which ﬁ rm to acquire within these countries without being concerned about differential exchange rate effects. If the MNC is also considering ﬁ rms in European countries that have not adopted the euro as their currency, however, it will still have to compare the potential exchange rate effects that could result from the acquisition. Impact of the Sarbanes-Oxley Act on the Pursuit of Targets In response to some major abuses in financial reporting by some MNCs such as Enron and WorldCom, the Sarbanes-Oxley (SOX) Act was implemented in 2002. The SOX Act improved the process for reporting profits used by U.S. firms (including U.S.-based MNCs). The SOX Act requires firms to document an orderly and transparent process for reporting, so that they cannot distort their earnings. The SOX Act also requires more accountability for oversight by executives and the board of directors. This increased accountability has had a direct impact on the process for assessing acquisitions. Executives of MNCs are prompted to conduct a more thorough review of the target firm’s operations and risk (called due diligence). In addition, the board of directors of an MNC conducts a more thorough review of any proposed acquisitions before agreeing to them. MNCs increasingly hire outside advisers (including attorneys and investment banks) to offer their assessment of proposed acquisitions. If a firm pursues an acquisition, financial information of the target is consolidated with that of the acquirer, and the acquirer must ensure that financial information of the target is accurate. ■

GOVE ER RN NA AN NC CE E

Factors That Affect the Expected Cash Flows of the Foreign Target When an MNC estimates the future cash ﬂows that it will ultimately receive after acquiring a foreign target, it considers several factors that reﬂect either conditions in the country of concern or conditions of the target itself.

Target-Specific Factors The following characteristics of the foreign target are typically considered when estimating the cash ﬂows that the target will provide to the parent.

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Target’s Previous Cash Flows. Since the foreign target has been conducting business, it has a history of cash ﬂows that it has generated. The recent cash ﬂows per period may serve as an initial base from which future cash ﬂ ows per period can be estimated after accounting for other factors. Since the target ﬁ rm has already been conducting business, it may be easier to estimate the cash ﬂows it will generate than to estimate the cash ﬂows to be generated from a new foreign subsidiary. A company’s previous cash ﬂows are not necessarily an accurate indicator of future cash ﬂows, however, especially when the target’s future cash ﬂows would have to be converted into the acquirer’s home currency as they are remitted to the parent. Therefore, the MNC needs to carefully consider all the factors that could inﬂuence the cash ﬂows that will be generated from a foreign target.

Managerial Talent of the Target. An acquiring ﬁ rm must assess the target’s existing management so that it can determine how the target ﬁ rm will be managed after the acquisition. The way the acquirer plans to deal with the managerial talent will affect the estimated cash ﬂows to be generated by the target. If the MNC acquires the target, it may allow the target ﬁ rm to be managed as it was before the acquisition. Under these conditions, however, the acquiring ﬁ rm may have less potential for enhancing the target’s cash ﬂows. A second alternative for the MNC is to downsize the target ﬁ rm after acquiring it. For example, if the acquiring ﬁ rm introduces new technology that reduces the need for some of the target’s employees, it can attempt to downsize the target. Downsizing reduces expenses but may also reduce productivity and revenue, so the effect on cash ﬂows can vary with the situation. In addition, an MNC may encounter signiﬁcant barriers to increasing efﬁciency by downsizing in several countries. Governments of some countries are likely to intervene and prevent the acquisition if downsizing is anticipated. A third alternative for the MNC is to maintain the existing employees of the target but restructure the operations so that labor is used more efﬁciently. For example, the MNC may infuse its own technology into the target ﬁ rm and then restructure operations so that many of the employees receive new job assignments. This strategy may cause the acquirer to incur some additional expenses, but there is potential for improved cash ﬂows over time.

Country-Specific Factors An MNC typically considers the following country-speciﬁc factors when estimating the cash ﬂows that will be provided by the foreign target to the parent.

Target’s Local Economic Conditions. Potential targets in countries where economic conditions are strong are more likely to experience strong demand for their products in the future and may generate higher cash ﬂows. However, some ﬁ rms are more sensitive to economic conditions than others. Also, some acquisitions of ﬁ rms are intended to focus on exporting from the target’s home country, so the economic conditions in the target’s country may not be as important. Economic conditions are difﬁcult to predict over a long-term period, especially for emerging countries. Target’s Local Political Conditions. Potential targets in countries where political conditions are favorable are less likely to experience adverse shocks to their cash ﬂows. The sensitivity of cash ﬂows to political conditions is dependent on the ﬁ rm’s type of business. Political conditions are also difﬁcult to predict over a long-term period, especially for emerging countries. If an MNC plans to improve the efﬁciency of a target by laying off employees that are not needed, it must ﬁ rst make sure that the government would allow layoffs

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before it makes the acquisition. Some countries offer protection of employees from layoffs, which may cause many of their ﬁ rms to be inefﬁcient. An MNC might not be capable of improving the efﬁciency if it is not allowed to lay off employees.

Target’s Industry Conditions. Industry conditions within a country can cause some targets to be more desirable than others. Some industries in a particular country may be extremely competitive while others are not. In addition, some industries exhibit strong potential for growth in a particular country, while others exhibit very little potential. When an MNC assesses targets among countries, it would prefer a country where the growth potential for its industry is high and the competition within the industry is not excessive.

H T T P : // http://research.stlouisfed .org/fred2 Numerous economic and ﬁnancial time series, e.g., on balance-of-payments statistics, interest rates, and foreign exchange rates.

Target’s Currency Conditions. If a U.S.-based MNC plans to acquire a foreign target, it must consider how future exchange rate movements may affect the target’s local currency cash ﬂows. It must also consider how exchange rates will affect the conversion of the target’s remitted earnings to the U.S. parent. In the typical case, ideally the foreign currency would be weak at the time of the acquisition (so that the MNC’s initial outlay is low) but strengthen over time as funds are periodically remitted to the U.S. parent. There can be exceptions to this general statement, but the point is that the MNC forecasts future exchange rates and then applies those forecasts to determine the impact on cash ﬂows.

Target’s Local Stock Market Conditions. Potential target ﬁ rms that are publicly held are continuously valued in the market, so their stock prices can change rapidly. As the target ﬁ rm’s stock price changes, the acceptable bid price necessary to buy that ﬁ rm will likely change as well. Thus, there can be substantial swings in the purchase price that would be acceptable to a target. This is especially true for publicly traded ﬁ rms in emerging markets in Asia, Eastern Europe, and Latin America where stock prices commonly change by 5 percent or more in a week. Therefore, an MNC that plans to acquire a target would prefer to make its bid at a time when the local stock market prices are generally low. Taxes Applicable to the Target. When an MNC assesses a foreign target, it must estimate the expected after-tax cash ﬂows that it will ultimately receive in the form of funds remitted to the parent. Thus, the tax laws applicable to the foreign target are used to derive the after-tax cash ﬂows. First, the applicable corporate tax rates are applied to the estimated future earnings of the target to determine the after-tax earnings. Second, the after-tax proceeds are determined by applying any withholding tax rates to the funds that are expected to be remitted to the parent in each period. Third, if the acquiring ﬁ rm’s government imposes an additional tax on remitted earnings or allows a tax credit, that tax or credit must be applied.

Example of the Valuation Process Lincoln Co. desires to expand in Latin America or Canada. The methods Lincoln uses to initially screen targets in various countries and then to estimate a target’s value are discussed next.

International Screening Process Lincoln Co. considers the factors just described when it conducts an initial screening of prospective targets. It has identiﬁed prospective targets in Mexico, Brazil, Colombia, and Canada, as shown in Exhibit 15.1. The target in Mexico has no plans to sell

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its business and is unwilling to even consider an offer from Lincoln Co. Therefore, this ﬁ rm is no longer considered. Lincoln anticipates potential political problems that could create barriers to an acquisition in Colombia, even though the Colombian target is willing to be acquired. Stock market conditions are not favorable in Brazil, as the stock prices of most Brazilian companies have recently risen substantially. Lincoln does not want to pay as much as the Brazilian target is now worth based on its prevailing market value. Based on this screening process, the only foreign target that deserves a closer assessment is the target in Canada. According to Lincoln’s assessment, Canadian currency conditions are slightly unfavorable, but this is not a reason to eliminate the target from further consideration. Thus, the next step would be for Lincoln to obtain as much information as possible about the target and conditions in Canada. Then Lincoln can use this information to derive the target’s expected cash ﬂows and to determine whether the target’s value exceeds the initial outlay that would be required to purchase it, as explained next.

Estimating the Target’s Value Once Lincoln Co. has completed its initial screening of targets, it conducts a valuation of all targets that passed the screening process. Lincoln can estimate the present value of future cash ﬂows that would result from acquiring the target. This estimation is then used to determine whether the target should be acquired. Continuing with our simpliﬁed example, Lincoln’s screening process resulted in only one eligible target, a Canadian ﬁ rm. Assume the Canadian ﬁ rm has conducted all of its business locally. Assume also that Lincoln expects that it can obtain materials at a lower cost than the target can because of its relationships with some Canadian suppliers and that it also expects to implement a more efﬁcient production process. Lincoln also plans to use its existing managerial talent to manage the target and thereby reduce the administrative and marketing expenses incurred by the target. It also expects that the target’s revenue will increase when its products are sold under Lincoln’s name. Lincoln expects to maintain prices of the products as they are. The target’s expected cash ﬂows can be measured by ﬁ rst determining the revenue and expense levels in recent years and then adjusting those levels to reﬂect the changes that would occur after the acquisition.

Revenue. The target’s annual revenue has ranged between C$80 million and C$90 million in Canadian dollars (C$) over the last 4 years. Lincoln Co. expects that it can improve sales, and forecasts revenue to be C$100 million next year, C$93.3 million in the following year, and C$121 million in the year after. The cost of goods sold has been about 50 percent of the revenue in the past, but Lincoln expects it will fall to Exhibit 15.1

Example of Process Used to Screen Foreign Targets Is the Target Receptive to an Acquisition?

Local Economic and Industry Conditions

Local Political Conditions

Local Currency Conditions

Prevailing Stock Market Prices

Tax Laws

Mexico

No

Favorable

OK

OK

OK

May change

Brazil

Maybe

OK

OK

OK

Too high

May change

Colombia

Yes

Favorable

Volatile

Favorable

OK

Reasonable

Canada

Yes

OK

Favorable

Slightly unfavorable

OK

Reasonable

Target Based in:

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40 percent of revenue because of improvements in efﬁciency. The estimates are shown in Exhibit 15.2.

Expenses. Selling and administrative expenses have been about C$20 million annually, but Lincoln believes that through restructuring it can reduce these expenses to C$15 million in each of the next 3 years. Depreciation expenses have been about C$10 million in the past and are expected to remain at that level for the next 3 years. The Canadian tax rate on the target’s earnings is expected to be 30 percent. Earnings and Cash Flows. Given the information assumed here, the after-tax earnings that the target would generate under Lincoln’s ownership are estimated in Exhibit 15.2. The cash ﬂows generated by the target are determined by adding the depreciation expenses back to the after-tax earnings. Assume that the target will need C$5 million in cash each year to support existing operations (including the repair of existing machinery) and that the remaining cash ﬂow can be remitted to the U.S. parent. Assume that the target ﬁ rm is ﬁ nancially supported only by its equity. It currently has 10 million shares of stock outstanding that are priced at C$17 per share. Cash Flows to Parent. Since Lincoln’s parent wishes to assess the target from its own perspective, it focuses on the dollar cash ﬂows that it expects to receive. Assuming no additional taxes, the expected cash ﬂows generated in Canada that are to be remitted to Lincoln’s parent are converted into U.S. dollars at the expected exchange rate at the end of each year. Lincoln uses the prevailing exchange rate of the Canadian dollar (which is $.80) as the expected exchange rate for the Canadian dollar in future years. Exhibit 15.2

Valuation of Canadian Target Based on the Assumptions Provided (in Millions of Dollars) Last Year

Year 1

Year 2

Year 3

Revenue

C$90

C$100

C$93.3

C$121

Cost of goods sold

C$45

C$40

C$37.3

C$ 48.4

Gross proﬁt

C$45

C$60

C$56

C$ 72.6

Selling & administrative expenses

C$20

C$15

C$15

C$15

Depreciation

C$10

C$10

C$10

C$10

Earnings before taxes

C$15

C$35

C$31

C$47.6

Tax (30%)

C$ 4.5

C$10.5

C$ 9.3

C$14.28

Earnings after taxes

C$10.5

C$24.5

C$21.7

C$33.32

C$10

C$10

C$10

C$5

C$5

C$5

Depreciation Funds to reinvest Sale of ﬁrm after capital gains taxes Cash ﬂows in C$

C$230 C$29.5 .80

C$26.7 $

.80

C$268.32

Exchange rate of C$

$

$

.80

Cash ﬂows in $

$23.6

$21.36

$214.66

PV (20% discount rate)

$19.67

$14.83

$124.22

Cumulative PV

$19.67

$34.50

$158.72

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Estimating the Target’s Future Sales Price. If Lincoln purchases the target, it will sell the target in 3 years, after improving the target’s performance. Lincoln expects to receive C$230 million (after capital gains taxes) from the sale. The price at which the target can actually be sold will depend on its expected future cash ﬂows from that point forward, but those expected cash ﬂows are partially dependent on its performance prior to that time. Thus, Lincoln can enhance the sales price by improving the target’s performance over the 3 years it plans to own the target.

Valuing the Target Based on Estimated Cash Flows. The expected U.S. dollar cash ﬂows to Lincoln’s parent over the next 3 years are shown in Exhibit 15.2. The high cash ﬂow in Year 3 is due to Lincoln’s plans to sell the target at that time. Assuming that Lincoln has a required rate of return of 20 percent on this project, the cash ﬂows are discounted at that rate to derive the present value of target cash ﬂows. From Lincoln’s perspective, the present value of the target is about $158.72 million. Given that the target’s shares are currently valued at C$17 per share, the 10 million shares are worth C$170 million. At the prevailing exchange rate of $.80 per dollar, the target is currently valued at $136 million by the market (computed as C$170 million $.80). Lincoln’s valuation of the target of about $159 million is about 17 percent above the market valuation. However, Lincoln will have to pay a premium on the shares to persuade the target’s board of directors to approve the acquisition. Premiums commonly range from 10 to 40 percent of the market price. If Lincoln allows for a premium of 10 percent above the prevailing stock price of C$17 per share, it would pay C$18.7 per share for the target. At this price per share, the price paid for the Canadian ﬁ rm would be C$187 million, or $149.6 million at the existing exchange rate. This price is less than the perceived net present value of the target, so Lincoln may be willing to pay this amount. Lincoln recognizes that the target may reject its offer of a 10 percent premium and ask for a higher premium, but it will not pay more than its estimate of the target’s net present value. Since Lincoln values the target at about $159 million, it will not pay more than about C$199 million at the prevailing exchange rate (computed as $159 million divided by $.80 per Canadian dollar), or a share price of C$19.90 (computed as C$199 million divided by 10 million shares). Sources of Uncertainty. This example shows how the acquisition of a publicly traded foreign ﬁ rm differs from the creation of a new foreign subsidiary. Although the valuation of a publicly traded foreign ﬁ rm can utilize information about an existing business, the cash ﬂows resulting from the acquisition are still subject to uncertainty for several reasons, which can be identiﬁed by reviewing the assumptions made in the valuation process. First, the growth rate of revenue is subject to uncertainty. If this rate is overestimated (perhaps because Canadian economic growth is overestimated), the earnings generated in Canada will be lower, and cash ﬂows remitted to the U.S. parent will be lower as well. Second, the cost of goods sold could exceed the assumed level of 40 percent of revenue, which would reduce cash ﬂows remitted to the parent. Third, the selling and administrative expenses could exceed the assumed amount of C$15 million, especially when considering that the annual expenses were C$20 million prior to the acquisition. Fourth, Canada’s corporate tax rate could increase, which would reduce the cash ﬂows remitted to the parent. Fifth, the exchange rate of the Canadian dollar may be weaker than assumed, which would reduce the cash ﬂows received by the parent. Sixth, the estimated selling price of the target 3 years from now could be incorrect for any of these ﬁve reasons, and this estimate is very inﬂuential on the valuation of the target today.

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Since one or more of these conditions could occur, the estimated net present value of the target could be overestimated. Consequently, it is possible for Lincoln to acquire the target at a purchase price exceeding its actual value. In particular, the future cash ﬂows are very sensitive to exchange rate movements. This can be illustrated by using sensitivity analysis and reestimating the value of the target based on different scenarios for the exchange rate over time.

Changes in Valuation over Time If Lincoln Co. decides not to bid for the target at this time, it will need to redo its analysis if it later reconsiders acquiring the target. As the factors that affect the expected cash ﬂows or the required rate of return from investing in the target change, so will the value of the target.

Impact of Stock Market Conditions. A change in stock market conditions affects the price per share of each stock in that market. Thus, the value of publicly traded ﬁ rms in that market will change. Remember that an acquirer needs to pay a premium above the market valuation to acquire a foreign ﬁ rm. Continuing with our example involving Lincoln Co.’s pursuit of a Canadian target, assume that the target ﬁ rm has a market price of C$17 per share, representing a valuation of C$170 million, but that before Lincoln makes its decision to acquire the target, the Canadian stock market level rises by 20 percent. If the target’s stock price rises by this same percentage, the ﬁ rm is now valued at New stock price 5 C$170 million 3 1.2 5 C$204 million Using the 10 percent premium assumed in the earlier example, Lincoln must now pay C$224.4 million (computed as C$204 million 1.1) if it wants to acquire the target. This example illustrates how the price paid for the target can change abruptly simply because of a change in the general level of the stock market.

Impact of Stock Market Conditions on the Value of Private Firms. Even if a target is privately held, general stock market conditions will affect the amount that an acquirer has to pay for the target because a privately held company’s value is inﬂuenced by the market price multiples of related ﬁ rms in the same country. A simple method of valuing a private company is to apply the price-earnings (P/E) ratios of publicly traded ﬁ rms in the same industry to the private company’s annual earnings. For example, if the annual earnings of a private Canadian company are C$8 million and the average P/E ratio of publicly traded Canadian ﬁ rms in the same industry is 15, the company’s market valuation can be estimated as Market valuation 5 Earnings 3 Average P/E ratio 5 C$8 million 3 15 5 C$120 million If the stock market level rises by 20 percent, the average P/E ratio of the ﬁ rms in the same industry will likely rise by about 20 percent, which represents an increase in the P/E ratio from 15 to 18. The new market valuation of the Canadian ﬁ rm will be New market valuation 5 C$8 million 3 18 5 C$144 million As this example illustrates, private companies also become more expensive targets when local stock market conditions improve.

Inﬂuence of Czech Stock Market and Currency Conditions on the Cost of Acquiring a Czech Target

Change in Stock Market Level (%)

20 12 10 8 6 4 2 0 –2 –4 –6 –8 –10 –12 –20

12 10 6 4 0

0 –1

–7

–6 –9

–12 –16 May June July Aug. Sept. Oct. Nov. Dec. Jan. Feb. Mar. Apr. Year 1

Year 2

Change in Koruna (%)

20 12 10 8 6 4 2 0 –2 –4 –6 –8 –10 –12 –20

8 4

4

3.4

3

0 –3

–4

0

0

–4 –8

May June July Aug. Sept. Oct. Nov. Dec. Jan. Feb. Mar. Apr. Year 1

Year 2

22 20

20 13

Change in Cost of Acquiring Target (%)

Exhibit 15.3

12 10 8 6 4 2 0 –2 –4 –6 –8 –10 –12 –20 –22

6 1 –1 –3

–3

–4

–4 –9 –12

–20 May June July Aug. Sept. Oct. Nov. Dec. Jan. Feb. Mar. Apr. Year 1

Year 2

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Impact of Exchange Rates. Whether a foreign target is publicly traded or private, a U.S. acquirer must convert dollars to the local currency to purchase the target. If the foreign currency appreciates by the time the acquirer makes payment, the acquisition will be more costly. The cost of the acquisition changes in the same proportion as the change in the exchange rate. Combined Stock Market and Exchange Rate Effects. In reality, stock market levels and exchange rates change simultaneously. The effects on the cost of acquiring a foreign target are especially pronounced in emerging markets where stock and currency values are volatile. Mizner, Inc., a U.S. firm, wants to acquire a firm in the Czech Republic so that it can expand its business in Eastern Europe. The Czech target’s valuation moves in tandem with general Czech stock market conditions. Exhibit 15.3, which is based on actual data from a recent period, shows how the cost to Mizner of acquiring the Czech target could change over time, even though the performance of the firm itself does not change. During the period shown, the cost of acquisition could have increased by 20 percent in a single month (December of Year 1) as a result of a very strong stock market in that month and also appreciation of the Czech currency (koruna). At the other extreme, the cost of the acquisition declined by 20 percent in a single month (March of Year 2) as a result of a weakening stock market and koruna over that month. This exhibit illustrates how sensitive the cost of an acquisition of a foreign target is to foreign market conditions. ■

E X X A M P L E

Impact of Market Anticipation Regarding the Target. The stock price of the target may increase if investors anticipate that the target will be acquired, since they are aware that stock prices of targets rise abruptly after a bid by the acquiring ﬁ rm. Thus, it is important that Lincoln keep its intentions about acquiring the target conﬁdential.

Why Valuations of a Target May Vary among MNCs Most MNCs that consider acquiring a speciﬁc target will use a somewhat similar process for valuing the target. Nevertheless, their valuations will differ because of differences in the way the MNC’s estimate the key determinants of a given target’s valuation: (1) cash ﬂows to be generated by the target, (2) exchange rate effects on funds remitted to the MNC’s parent, and (3) the required rate of return when investing in the target.

Estimated Cash Flows of the Foreign Target The target’s expected future cash ﬂows will vary among MNCs because the cash ﬂows will be dependent on the MNC’s management or oversight of the target’s operations. If an MNC can improve the production efﬁciency of the target without reducing the target’s production volume, it can improve the target’s cash ﬂows. Each MNC may have a different plan as to how the target will ﬁt within its structure and how the target will conduct future operations. The target’s expected cash ﬂows will be inﬂuenced by the way it is utilized. An MNC with production plants in Asia that purchases another Asian production plant may simply be attempting to increase its market share and production capacity. This MNC’s cash ﬂows change because of a higher production and sales level. Conversely, an MNC with all of its production plants in the United States may purchase an Asian production plant to shift its production where costs are lower. This MNC’s cash ﬂows change because of lower expenses.

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Tax laws can create competitive advantages for acquirers based in some countries. Acquirers based in low-tax countries may be able to generate higher cash ﬂows from acquiring a foreign target than acquirers in high-tax countries simply because they are subject to lower taxes on the future earnings remitted by the target (after it is acquired).

Exchange Rate Effects on the Funds Remitted The valuation of a target can vary among MNCs simply because of differences in the exchange rate effects on funds remitted by the foreign target to the MNC’s parent. If the target remits funds frequently in the near future, its value will be partially dependent on the expected exchange rate of the target’s local currency in the near future. If the target does not remit funds in the near future, its value is more dependent on its local growth strategy and on exchange rates in the distant future.

Required Return of Acquirer The valuation of the target could also vary among MNCs because of differences in their required rate of return from investing funds to acquire the target. If an MNC targets a successful foreign company with plans to continue the target’s local business in a more efﬁcient manner, the risk of the business will be relatively low, and therefore the MNC’s required return from acquiring the target will be relatively low. Conversely, if an MNC targets the company because it plans to turn the company into a major exporter, the risk is much higher. The target has not established itself in foreign markets, so the cash ﬂows that would result from the exporting business are very uncertain. Thus, the required return to acquire the target company will be relatively high as well. If potential acquirers are based in different countries, their required rates of return from a speciﬁc target will vary even if they plan to use the target in similar ways. Recall that an MNC’s required rate of return on any project is dependent on the local riskfree interest rate (since that inﬂuences the cost of funds for that MNC). Therefore, the required rate of return for MNCs based in countries with relatively high interest rates such as Brazil and Venezuela may differ from MNCs based in low-interest-rate countries such as the United States or Japan. The higher required rate of return for MNCs based in Latin American countries will not necessarily lead to a lower valuation. The target’s currency might be expected to appreciate substantially against Latin American currencies (since some Latin American currencies have consistently weakened over time), which would enhance the amount of cash ﬂows received as a result of remitted funds and could possibly offset the effects of the higher required rate of return.

Other Types of Multinational Restructuring Besides acquiring foreign ﬁ rms, MNCs can engage in multinational restructuring through international partial acquisitions, acquisitions of privatized businesses, international alliances, and international divestitures. Each type is described in turn.

International Partial Acquisitions In many cases, an MNC may consider a partial international acquisition of a ﬁ rm, in which it purchases part of the existing stock of a foreign ﬁ rm. A partial international acquisition requires less funds because only a portion of the foreign target’s shares are purchased. With this type of investment, the foreign target normally continues operating and may not experience the employee turnover that commonly occurs after a target’s ownership changes. Nevertheless, by acquiring a substantial fraction of the shares, the MNC may have some inﬂuence on the target’s management and is in a

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position to complete the acquisition in the future. Some MNCs buy substantial stakes in foreign companies to have some control over their operations. For example, CocaCola has purchased stakes in many foreign bottling companies that bottle its syrup. In this way, it can ensure that the bottling operations meet its standards.

Valuation of a Foreign Firm That May Be Partially Acquired. When an MNC considers a partial acquisition in which it will purchase sufﬁcient shares so that it can control the ﬁ rm, the MNC can conduct its valuation of the target in much the same way as when it purchases the entire ﬁ rm. If the MNC buys only a small proportion of the ﬁ rm’s shares, however, the MNC cannot restructure the ﬁ rm’s operations to make it more efﬁcient. Therefore, its estimates of the ﬁ rm’s cash ﬂows must be made from the perspective of a passive investor rather than as a decision maker for the ﬁ rm.

International Acquisitions of Privatized Businesses In recent years, government-owned businesses of many developing countries in Eastern Europe and South America have been sold to individuals or corporations. Many MNCs have capitalized on this wave of so-called privatization by acquiring businesses being sold by governments. These businesses may be attractive because of the potential for MNCs to increase their efﬁciency.

Valuation of a Privatized Business. An MNC can conduct a valuation of a foreign business that was owned by the government in a developing country by using capital budgeting analysis, as illustrated earlier. However, the valuation of such businesses is difﬁcult for the following reasons: • The future cash ﬂows are very uncertain because the businesses were previously operating in environments of little or no competition. Thus, previous sales volume ﬁgures may not be useful indicators of future sales. • Data concerning what businesses are worth are very limited in some countries because there are not many publicly traded ﬁ rms in their markets, and there is limited disclosure of prices paid for targets in other acquisitions. Consequently, there may not be any benchmarks to use when valuing a business. • Economic conditions in these countries are very uncertain during the transition to a market-oriented economy. • Political conditions tend to be volatile during the transition, as government policies for businesses are sometimes unclear or subject to abrupt changes. • If the government retains a portion of the ﬁ rm’s equity, it may attempt to exert some control over the ﬁ rm. Its objectives may be very different from those of the acquirer, a situation that could lead to conﬂ ict. Despite these difﬁculties, MNCs such as IBM and PepsiCo have acquired privatized businesses as a means of entering new markets. Hungary serves as a model country for privatizations. More than 25,000 MNCs have a foreign stake in Hungary’s businesses. Hungary’s government has been quick and efﬁcient at selling off its assets to MNCs.

International Alliances MNCs commonly engage in international alliances such as joint ventures and licensing agreements with foreign ﬁ rms. International alliances are quite different from international acquisitions. The initial outlay is typically smaller because the MNC is not acquiring a foreign ﬁ rm, and the cash ﬂows to be received are typically smaller as well.

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Part 4: Long-Term Asset and Liability Management Laredo, Inc., plans to provide a Mexican firm with technology. In return, the Mexican firm will pay royalties amounting to 10 percent of its future sales of products resulting from use of this technology over the next 5 years. Laredo’s initial outlay for this international alliance is the initial expense incurred as a result of providing the technology. Laredo can estimate the cash flows to be received from the Mexican firm by first forecasting the Mexican firm’s annual sales (in pesos) of products based on the technology. Laredo will receive 10 percent of this amount. Then, it must forecast the value of the peso over each of the next 5 years so that it can determine the dollar cash flows resulting from these royalties. It must also consider any tax effects. ■

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International Divestitures An MNC should periodically reassess its direct foreign investments to determine whether they should be retained or sold (divested). Some foreign projects may no longer be feasible as a result of the MNC’s increased cost of capital, increased host government taxes, increased political risk in the host country, or revised projections of exchange rates. Many divestitures occur as a result of a revised assessment of industry or economic conditions. For example, Pﬁzer, Johnson & Johnson, and several other U.S.-based MNCs recently divested some of their Latin American subsidiaries when economic conditions deteriorated there.

Assessing Whether to Divest Existing Operations in Asia. During the Asian crisis in the 1997–1998 period, some MNCs with direct foreign investment in Asia reassessed the feasibility of their existing operations. The expected cash ﬂows that these operations would generate for the parent had declined in many cases for two obvious reasons. First, the rate of economic growth in Asia declined, which led to a decline in expected local sales by the foreign subsidiaries and therefore a decline in the expected level of foreign currency cash ﬂow. Second, the weak currencies of Asian countries led to a decline in the expected amount of the parent’s currency to be received when foreign subsidiaries in Asian countries remitted funds. At the same time, however, market valuations had declined so much that any operations could be divested only if the parent was willing to sell them at a low price. The low prices deterred some divestitures.

Valuation of an International Project That May Be Divested. The valuation of a proposed international divestiture can be determined by comparing the present value of the cash ﬂows if the project is continued to the proceeds that would be received (after taxes) if the project is divested. Reconsider the example from the previous chapter in which Spartan, Inc., considered establishing a Singapore subsidiary. Assume that the Singapore subsidiary was created and, after 2 years, the spot rate of the Singapore dollar (S$) is $.46. In addition, forecasts have been revised for the remaining 2 years of the project, indicating that the Singapore dollar should be worth $.44 in Year 3 and $.40 in the project’s final year. Because these forecasted exchange rates have an adverse effect on the project, Spartan, Inc., considers divesting the subsidiary. For simplicity, assume that the original forecasts of the other variables remain unchanged and that a potential acquirer has offered S$13 million (after adjusting for any capital gains taxes) for the subsidiary if the acquirer can retain the existing working capital. Spartan can conduct a divestiture analysis by comparing the after-tax proceeds from the possible sale of the project (in U.S. dollars) to the present value of the expected U.S. dollar inflows that the project will generate if it is not sold. This comparison will determine the net present value of the divestiture (NPVd), as illustrated in Exhibit 15.4. Since the present value of the subsidiary’s cash flows from Spartan’s perspective exceeds the price at which it can sell the subsidiary, the divestiture is not feasible. Thus, Spartan should not divest the subsidiary at

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Chapter 15: International Acquisitions Exhibit 15.4

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Divestiture Analysis: Spartan, Inc. End of Year 3 (One Year from Today)

End of Year 4 (Two Years from Today)

S$6,840,000

S$19,560,000

$.44

$.40

Cash ﬂows forgone due to divestiture

$3,009,600

$7,824,000

PV of forgone cash ﬂows (15% discount rate)

$2,617,044

$5,916,068

End of Year 2 (Today) S$ remitted after withholding taxes Selling price

S$13,000,000

Exchange rate

$.46

Cash ﬂow received from divestiture

$5,980,000

NPVd $5,980,000 ($2,617,044 $5,916,068) $5,980,000 $8,533,112 $2,553,112

the price offered. Spartan may still search for another firm that is willing to acquire the subsidiary for a price that exceeds its present value. ■

Restructuring Decisions as Real Options Some restructuring issues faced by MNCs involve real options, or implicit options on real assets (such as buildings, machinery, and other assets used by MNCs to facilitate their production). A real option can be classiﬁed as a call option on real assets or a put option on real assets, as explained next.

Call Option on Real Assets A call option on real assets represents a